Markets have firmed up their expectations for a European Central Bank interest rate hike this month with the bank's President striking a hawkish tone but are proving reluctant to price in further tightening. Greece's debt crisis had cast doubt on whether the European Central Bank would go ahead with a 25 basis point rate increase to 1.50 percent at its July 7 meeting, which was flagged at the bank's policy meeting early this month.
ECB President Jean-Claude Trichet dashed such speculation on Thursday, saying the central bank was in "strong vigilance" mode as data showed inflation in June stabilised well above the bank's target. Although markets are now fully pricing in a July interest rate hike, the December Euribor interest rate future shows a further rate rise this year only around 70 percent priced in, ING said.
"That's too little given from the comments from Trichet this week we get the idea the central bank is still worried inflation expectations can pick up," said the bank's strategist Alessandro Giansanti. He also pointed to Italy's Mario Draghi taking over as President of the ECB in November. "Reading (Draghi's) past speeches, we should expect a more hawkish stance than his predecessor."
Expectations earlier this year had been for quarterly interest rate hikes, with the ECB making its first move in April. "As the risk of a tail event (from the Greek debt crisis) diminishes, the market has to price a return to the likely path of quarterly rate hikes until January, which would take the refinancing rate to 2 percent, and then on hold," said Morgan Stanley rate strategist Laurence Mutkin.
But analysts disagree on whether further tightening should be factored in. A second hike is being priced in for February, according to forward overnight interest rate swap rates, with between one and two more by the end of 2012, strategists said. Bank strategist Matteo Regesta believes the market currently has rate expectations correctly priced. "It's a fine balance and unfortunately I believe the sovereign debt crisis will continue to negatively surprise for the next months and years," Regesta said.
"As a result the usual smooth trajectories of monetary policy we have been used to in the past no longer apply." Purchasing manager data showed the euro zone's manufacturing sector lost steam last month with Spain's manufacturing sector contracting at its fastest rate in a year and a half and the Italian sector also contracting. "The market isn't reacting irrationally to the data in pricing such a flat term premium," said RBS rate strategist Harvinder Sian.
"The credibility of further rate hikes against this data backdrop is what is causing the market to have a fairly low estimate of where we go from here." Nonetheless, renewed certainty that the ECB will hike next month, while there is no sign at all of the Federal Reserve and Bank of England contemplating monetary tightening, has pushed the eurozone 2/10 year interest rate swap curve flatter versus the UK and US equivalents.
The relative moves of the sterling curve versus that of euro rates are known as a "box" and market players trade by placing a flattening position on one curve versus a steepening position on the other. The box is at its highest levels in almost 20 years at just above 100 basis points, according to Reuters data, against a backdrop of sluggish UK economic growth. The US/euro zone 2/10 box has also risen 30 bps to around 80 bps in the last week. Three-month euro Libor rates rose 0.7 bps to 1.49813 percent, the highest in over three-years, with equivalent US rates unchanged at 0.24575 percent.