Sterling interbank lending rates hit an 18-month high on Monday ahead of this week's Bank of England policy meeting, with markets pricing in an outside chance of an interest rate hike. UK inflation hit an eight-month high of 3.7 percent in December, well above the BoE's 2 percent target, prompting two of the BoE's nine Monetary Policy Committee (MPC) members to vote for a rate hike in January.
With February's rate decision due on Thursday, British gilt futures fell to a contract low and two-year gilt yields rose to their highest in two years as investors positioned for the growing risk rates will soon start rising. Even though analysts polled by Reuters do not anticipate the central bank will hike rates this week given the patchiness of the economic recovery, Sonia forward overnight swap rates are pricing in a 25 percent chance that they might, according to Societe Generale.
A 25 basis point rate hike is however fully priced in for around the time of May's BoE policy meeting, with a second hike anticipated by September. "The market has got a bit excited," said SG's UK economist Brian Hilliard. The BoE's quarterly inflation update will be published on February 16. Benchmark three-month sterling Libor rates rose to 0.80 percent.
Equivalent euro rates eased, with overnight rates falling to 0.36 percent at Friday's fixing as excess liquidity in the banking system rose towards the end of the European Central Bank's reserve maintenance period, after banks increased their take up of ECB funds by over 50 billion euros last week.
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