Eurozone interest rate futures extended their recent rally on Friday as investors increased their bets that weak growth in the region and globally would lead the European Central Bank to ease policy before year-end. Euribor futures rallied by around 8 ticks across the curve, building on similar gains made on Thursday after data showing a widespread slowdown in eurozone manufacturing.
"There is a shift happening. With people looking at (ECB President Jean-Claude) Trichet's departure at the end of October the potential for a shift in policy is perhaps growing," said Simon Smith, chief economist at FxPro in London. "That's why you're seeing (longer-dated) contracts doing much better than the near months because people aren't thinking that policy will be changed straightaway but potential for an easing is growing."
The December contract rose 9 ticks to 98.78. That move, if sustained on a closing basis, could break the current pennant pattern on charts, sparking a sharp rally, said Mizuho technical analyst Nicole Elliott. "In theory, the contract could get up to 99.40. Obviously if it's going to do that then we must expect or be guaranteed a rate cut before the (delivery of the contract) in December, which is very possible," she said.
A more conservative target would be around 99.12 - the 61 percent Fibonacci level of the 70 basis point rise that makes up the pennant pattern's 'flagpole'. The near-term focus will fall on next week's ECB policy meeting with investors keen to gauge the extent to which Trichet will move back towards a more neutral policy stance after raising rates in July for the second time this year.
Strategists said they expected the bout of money market stress seen in August to continue, with some recommending trades to take advantage of long-term dependence on ECB funding and higher dollar funding costs in the coming months. Societe Generale targets a 14.5 bps fall in overnight rates linked to the November ECB meeting from current levels of 0.854 percent on the likelihood that liquidity will remain high, suppressing short-term rates, as banks struggle to regain access to interbank markets.
"We expect financial stress to remain elevated, keeping banks hungry for central bank liquidity," the bank's strategists said in a note. Similarly, dollar funding costs looked set to extend their recent rise, despite stabilising in recent sessions, with US money market funds likely to show increasing reluctance to lend to eurozone banks as the region's debt crisis rumbles on.
"At this juncture, it makes sense to see the recent easing in tensions as temporary," BNP Paribas strategists said in a note. The bank saw any significant decline in Libor/OIS spreads - which measure counterparty risk - as an opportunity to position for an anticipated re-widening. The benchmark dollar Libor rate fixed at 0.33056 percent on Friday, extending a steady rise from lows around 0.245 percent seen earlier this year. Eurodollar futures showed markets expect the three-month Libor fixing to rise, with the December contract pointing to a rate of around 57 bps.
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