European money market rates rose on Wednesday to 21-month highs as traders positioned for the European Central Bank to raise interest rates at its Thursday meeting for the first time in nearly three years. Current money market rates reflect expectations the ECB's main refinancing rate, currently at a record low 1.0 percent, will reach 1.75 percent by the end of the year, with a first 25 bps hike fully priced in for Thursday.
"The risk is they signal a slightly more aggressive rate hike this cycle and so we see a shift from expectations of two or three hikes to three or four," said one trader. But the ECB may be deterred from raising rates further by continued fiscal problems in Portugal and Spain and bank rescue costs in Ireland, analysts said. Conflict in Libya and the Middle East and Japan's struggle to contain the worst nuclear crisis in decades after last month's devastating earthquake and tsunami could also encourage caution.
"Given the uncertainties around global growth, and peripheral governments and banks, it would be hard for the ECB to deliver more than is priced in by the market while the (US Federal Reserve) remains on hold," Deutsche Bank rate strategists Mark Well and Francis Yared said in a note. The Fed is seen as unlikely to tighten policy until early 2012 as policymakers appear split on the timing of an end to its near-zero rate policy and other extraordinary measures brought in since 2008 to ease the effects of the financial crisis.
Benchmark three-month euro Libor rates fixed a basis point higher at 1.21938 percent. Portugal managed to raise another 1 billion euros although it had to pay up at Wednesday's sale of six- and 12-month T-bills, with borrowing costs at euro lifetime highs and rising.
Portuguese banks have threatened to stop buying government debt, of which they are major holders, urging the caretaker cabinet to seek a short-term loan to tide it over a pre-election limbo. The banks have been unable to raise funds for the best part of a year and analysts say they may need to raise their capital ratios to cope with the difficult environment and reduce their dependence on ECB loans.