Euribor futures rally

Markets cut expectations that the European Central Bank would raise interest rates again this year as the eurozone debt crisis spread to Italy, the region's third largest economy. Pricing of the overnight rate curve - used as a proxy for central bank rates - showed eurozone interest rates were now more likely to remain unchanged into year-end than to rise.
Less than a week ago the central bank raised rates to 1.5 percent and showed no sign of backing away from its intention to keep hiking to control inflation stemming from core European countries. Last Friday, markets were pricing in a good chance of a third rate hike.
Eonia rates linked to year-end were only 11bps higher than the implied rate for the ECB's August meeting - indicating less than a 50 percent chance of another hike this year. Euribor futures rallied across the 2011/12 strip, implying markets were expecting the upward pressure on interbank borrowing costs from interest rates to wane. Euribor and euro libor three-month interbank rates both fixed lower.
The December Euribor futures contract rallied by as much as 12 ticks before receding in line with volatile government bond market moves. Signs that the crisis, which has so far claimed Greece, Portugal and Ireland, could take down one of the region's largest economies also heightened tension in interbank markets, driving measures of counterparty risk higher.
The spread between Libor rates and overnight index swaps, which roughly equates to the risk premium added by lenders in the unsecured interbank market, spiked by 9 bps to 26 bps, its highest since early January. Dollar funding costs for eurozone banks also pushed higher. The one-year euro/dollar currency basis swap spread, which expands when dollars become more expensive, widened to 39 basis points, around 6 bps more than on Friday.