Short-dated euro rates remain up

Eurozone short-term interest rates jumped on Thursday after the European Central Bank said inflationary pressures had increased, using language understood by the market to mean a rate hike was imminent. The ECB kept interest rates on hold at 1 percent as expected but President Jean-Claude Trichet said inflationary risks were to the upside and "strong vigilance" was required, adding that an increase in the bank's main 1 percent refinancing rate in April was possible.
The ECB used the phrase "strong vigilance" repeatedly during its 2005-2007 rate hike cycle, typically one month before it raised rates, although there were exceptions to that rule. It is not clear whether the verbal signal still holds good. Short-dated rates jumped and two-year bond yields rose 20 bps on the day to hit their highest since mid-2009 at 1.76 percent.
"It looks like we're facing a rate hike very soon," said Credit Agricole rate strategist David Keeble. Overnight index swaps showed a step up in rate hike expectations with a first 25 basis point rise almost fully priced in June, compared with August earlier this week. A second hike is priced in September.
Analysts said that the market may not be pricing an immediate rate hike in April despite Trichet's strong language, because the ECB also extended its unlimited provision of fixed-rate funding to the banking sector when many had been expecting it to be pared back.
"It's very difficult to discern market expectations because of the interplay between the liquidity side where there was a dovish surprise and the rates side where there was a hawkish surprise," said Nomura rate strategist Sean Maloney. Data earlier this week showed euro zone inflation running at a 28-month high in February, well above the ECB's target. Central bankers have said they will act to ensure upside risks to price stability over the medium term do not materialise. Benchmark three-month Libor rates fixed at 1.048 percent ahead of the ECB meeting, with equivalent dollar rates steady at 0.3095 percent.