The eurozone interest rate futures curve flattened on Tuesday and banks grabbed funds from the ECB as markets questioned whether the central bank was right to raise interest rates last month faced with a spreading debt crisis and poor growth.
Market pricing already all but ruled out another rise in European Central Bank rates by the end of the first quarter, but the Euribor rate futures curve flattened further, with the September 2010 contract rising 7 ticks to leave little difference in prices between contracts over the next year.
Gloomy US data on Monday compounded worries about a slow down in the eurozone where manufacturing stagnated in July, pushing Italian government bond yields up by as much as 20 basis points to above 6 percent, and spreads over German Bunds to euro lifetime highs.
"Against the backdrop of weak data and systemic risks within the Periphery, the July ECB hike is looking increasingly more like a policy error and we expect the market to move towards pricing it as such," said RBS rate strategist Simon Peck.
The three-month spread between Libor rates and overnight indexed swap rates - an indicator of financial system stress -stress - rose around 7 bps to 38 bps, the most in almost 2 years. The uncertain backdrop saw banks take 8 billion euros more in one-week funds from the ECB for the last week of the bank's maintenance period, after already hoarding liquidity and front-loading their reserve requirements by the most since December.
The increase this week, taking into account lower reserve requirements, means excess liquidity will rise to 150 billion euros, Morgan Stanley said, the most since the last of the ECB's emergency 12-month financing operation matured in July 2010. Average July current account holdings versus the reserve requirement peaked at 37.5 billion euros, compared with 37.2 billion euros in June's maintenance period, Reuters data showed. Meanwhile, the cost of overnight dollar funding is expected to ease after Tuesday once the US Senate clears a deal to raise the US debt ceiling and avoid a default, but the threat of a rating downgrade will remain a worry.
Money market funds lost $38 billion in assets last week, the Investment Company reported, which has contributed to a jump in funding rates. The interest rates lenders charge on overnight loans backed by Treasuries as collateral jumped to 0.38 percent on Monday. That is a level that has only been seen at year- or quarter end - when demand for cash increases - in the last two-years, and up from just 0.04 percent two weeks ago. Overnight repo rates were 0.33 percent in early Tuesday trade. One-year euro/dollar cross-currency basis swaps - which show the rate charged when swapping euro interest payments on an underlying asset into dollars - were quoted at -42 bps, the most since January and around 8 bps wider over the last week.