Euro money market rates rose on Friday after the European Central Bank raised interest rates and signalled there was more tightening to come, suggesting markets may price in more than two further hikes by year-end. Markets are close to factoring in a further rate hike in the ECB's main refinancing rate - now at 1.25 percent - in June and it is more than fully priced by July, in line with the results of a Reuters poll conducted late on Thursday.
Benchmark three-month euro Libor rates fixed 1.5 bps higher, the biggest daily rise since early March when the ECB first signalled its intent to raise rates. Euribor interest rate futures fell across the strip, pushing implied rates higher and Eonia money market rates were around 5 bps higher at the six-month maturity. The ECB's refinancing rate is seen at 1.75 percent by year-end and Royal Bank of Scotland estimates markets are pricing a rate of around 2.61 percent by the end of 2012. But those pricings may have room to shift.
"The risk is skewed to the ECB front-loading rate hikes so there is the possibility of the refinancing rate at 2 percent by the end of 20011," said the bank's rate strategist Simon Peck.
If markets believe the ECB will front-load its rate hikes then the Euribor interest rate futures curve would flatten, with higher implied rates in 2011 and lower implied rates in 2012. That could be traded with a curve-flattening position, selling the December 2011 contract and buying the December 2012, Peck said. Commerzbank strategist Christoph Rieger said that based on previous ECB hiking cycles, two-year German government bond yields could also have room to head higher. He said that with 2-year Eonia forwards at 2.5 percent by December, two-year German Schatz yields were indicated around 2.35 percent at year-end, 60 bps above the implied refinancing rate of 1.75 percent shown by overnight indexed swap rates.
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