Money market investors have backed off from pricing in a cut in European Central Bank borrowing costs in October, raising forward interest rates and bringing their bets more into line with the bulk of economists. A deterioration in sentiment last week and some high profile calls for a sharp cut in the ECB's main rates had tempted markets to price in fully a 25 basis point reduction for next week.
But rhetoric from ECB officials has played against that idea and data on inflation and German unemployment also added to the case against what would be a dramatic U-turn at ECB President Jean-Claude Trichet's final meeting. RBC Capital Markets rate strategist Norbert Aul estimates the Eonia rate forwards curve is now pricing in only a 10-15 bps rise in October from more than 25 bps last week. "It is not only because of the German inflation. We have a little bit of a brighter picture, different options are being discussed behind closed doors at the moment," Aul said.
Reuters polling indicates the bank will cut at latest in the first quarter and money market traders said the overall feeling in the market is still that the ECB will cut rates soon. "There's been a lot of volatility, but liquidity is very thin and the ECB are very difficult to read," one trader said.
If eurozone inflation rises on Friday, the Eonia and Euribor curves could steepen further. "The spread between the September 2013 and December 2011 Euribor futures contract is very flat at 20 bps," said ING rate strategist Alessandro Giansanti. The overnight Eonia rate fixed virtually flat at 1.069 percent - a rate that is considered high given that markets lie on hefty excess liquidity levels of around 187 billion euros, according to Reuters calculations.
Analysts said Eonia was worth monitoring closely next week. If it does not fall, it means that the upward pressure is fuelled by increased interbank stress, not just by the fact that banks usually need more liquidity to balance their books at the turn of the quarter.
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