Overnight rates dropped and Euribor futures rallied on Thursday after the European Central Bank pledged new liquidity support for the eurozone banking system in an effort to ease rising tension in financial markets. The decision to give banks access to a one-off six-month funding operation and extend its three-month tenders until at least the end of the year should alleviate stress and keep money market rates low for longer, analysts said.
The eurozone''s debt crisis has spread to threaten Italy, which has the region''s largest government bond market and is seen as too big to be rescued, ramping up tension in interbank markets. Rates fell across the Eonia curve and Eonia forwards dropped in response to the prospect of a fresh batch of long-term liquidity hitting the market.
One-month Eonia was 8 basis points lower at 1.09 percent, and three-month rates dropped to 1.076 percent from 1.18 percent before ECB President Jean-Claude Trichet announced the measures at a news conference after the bank kept interest rates on hold. The overnight curve, which measures central bank rate expectations, was already flat going into Trichet''s news conference, pricing out rate hikes for around 12 months against a backdrop of weak global growth and increased uncertainty in eurozone bond markets.
Euribor futures, which also act as a proxy for central bank rates, rallied sharply, implying lower expected rates. The September 2012 contract rose the most, up by 20 ticks, as the recent flattening trend extended to contracts further out along the curve.
Earlier, against the backdrop of heightened money market tension, the cost at which banks can access dollar funding rose. Three-month dollar Libor rose for the eighth consecutive session to reach 0.26939 percent - its highest in two months.
The risk premium on unsecured dollar lending, measured by the gap between Libor and expected central bank rates, rose to 16 bps, surpassing recent peaks to hit its highest since April. However, the ECB''s support to the banking sector could encourage US institutions to deal with European banks and ease some of that tension, analysts said.