Euro-priced interbank rates rose on Friday but at a slower pace than in the past two weeks after the European Central Bank tempered expectations it could raise borrowing costs as early as August. The ECB left eurozone interest rates on hold at a record low of 1 percent on Thursday and said last month's larger than expected jump in inflation had not altered its assessment of medium-term price risks.
The repricing of interest rate hike expectations was, however, modest with interest rate futures implying a 90 percent probability of a 25 basis point rate increase by August. Before Thursday's meeting, the market was fully pricing in a rate hike by then.
Benchmark interbank rates edged up but more slowly than in the past two weeks, with three month Euribor up at 1.088 percent from 1.087 percent on Thursday. The equivalent Libor rate inched up to 1.03375 percent, its highest since July 2009.
Interbank rates have been moving higher every day since the ECB's meeting on January 13 when President Jean-Claude Trichet warned about rising inflation pressures in the euro zone, followed by hawkish rhetoric from other ECB policymakers. "Trichet had every reason to be more hawkish yesterday but he didn't have to because the markets were moving in the ECB's desired direction - money market rates seemed to be moving back towards the main refi rate, banks were asking for less liquidity from the ECB," said ICAP economist Don Smith.
ECB Vice President Vitor Constancio said on Friday he was satisfied with the reaction of financial markets to the bank's message from its first two policy meetings this year. Markets were expecting the ECB to resume the process of gradually removing its crisis liquidity support next month after Trichet said on Thursday that the recent reaction of overnight rates showed that the health of money markets had improved.
Markets were pricing in a normalisation of liquidity conditions - one of the key drivers of short-term money market rates - by June, with the anticipated overnight EONIA rate seen at the ECB's key refinancing rate of 1 percent. The overnight rate fixed at 0.526 percent on Thursday, the lowest since mid-January after banks increased their demand for one-week funds this week, pushing up surplus liquidity. The overnight EONIA rate topped 1 percent for the first time in 19 months last week after the level of surplus cash in the euro banking system plunged.
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