A rise in excess liquidity in the banking system could push eurozone overnight interest rates lower next week, but the increase may not be enough to bring them below 1 percent. Bets that the key refi rate will rise from the current level of 1.25 percent this summer has dampened banks' demand for 3-month cash from the European Central Bank (ECB), meaning excess liquidity will rise less than previously expected.
Banks borrowed 63.4 billion euros for 91 days on Wednesday, below the average expectation of 75 billion euros in a Reuters poll and the 71 billion in expiring funds. "Excess liquidity will be lower than expected, as of yesterday, after today's reduction at around 27 billion euros for the coming week," said Elaine Lin, interest rate strategist at Morgan Stanley. But the ECB's liquidity operations this week still leave an extra 13 billion euros in the system, after Tuesday's one-week cash offering of 118 billion euros, compared with 97 billion that expired.
That means Eonia rates are poised to fall, although they are likely to hold above 1 percent for the rest of the current reserve period, some 50 basis points higher than their lowest hit in the previous reserve period, analysts say. Barclays Capital's Giuseppe Maraffino said Eonia was trading at 1.25 percent in the first part of Wednesday's session and was expected to settle around that level - slightly lower than Tuesday's fixing at 1.297 percent.
He expected Eonia to remain around 1.25-1.3 percent this week and fall towards 1-1.1 percent next week as the end of the reserve period gets closer. Short sterling contracts fell some 10 basis points across the 2011-2012 strip after data showed the UK economy rebounded in the first quarter from a contraction at the end of last year. Lloyds strategist Eric Wand said markets are now pricing in a 64 percent probability the Bank of England will raise interest rates in August, up from 59 percent on Tuesday. The probability for a hike in October rose to 84 percent from 74 percent, he said. He recommended using the rise to sell August MPC-dated Sonia overnight rates when they rise above 0.69 percent, compared with their current level of 0.66 percent, on the view that UK economic activity will remain weak enough to warrant low interest rates for a longer period.