Eurozone money markets are on their way to pricing in three interest rate hikes this year but short-dated government bond yields paint a less hawkish picture and may have room to rise. With European Central Bank policy makers keeping up their hawkish tone after indicating rates could be raised as soon as April, overnight indexed swaps for December's ECB meeting hovered around 1.68 percent on Friday.
All other things being equal that reflects around a 70 percent chance of a third rate hike from the current 1.0 percent refinancing rate. Two-year German government bond yields - which should also price in the additional risk of being longer-term money - are also only around 1.7 percent.
"If the ECB does deliver 75 basis points then the two-year yield is far too low and consequently if the market really begins to price in the risk of 75 bps we should see a significantly flatter curve and two year yields (up to) 40 bps above where they are now," said ING rate strategist Padhraic Garvey.
Two-year German government bond yields are currently around 70 bps over the ECB's refinancing rate, around the same level as before the ECB's last hiking cycle began at the end of 2005. Once the ECB got going with its extended round of tightening, the spread then widened to around 95 bps by mid-2006.
Benchmark three-month euro Libor rates rose almost a basis point to 1.15 percent, with the effects of excess liquidity in the banking system keeping them pinned down. Equivalent dollar rates were barely changed at 0.30750 percent.
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