A 72 billion euro liquidity drain from the European monetary system fuelled expectations of higher interbank borrowing costs to come as bank-to-bank rates scaled 10-month highs on Tuesday. The London Interbank Offered Rate (Libor) in three-month euro funds EUR3MFSR= hit 0.74 percent at the London fixing, its highest level since Sept 9. Euro Libor has been creeping up since hitting a euro lifetime low of 0.57563 percent on April 1.

Similarly, the three-month Euribor bank-to-bank rate in Frankfurt earlier on Tuesday fixed at a 10-month high of 0.797 percent. The European Central Bank lent a combined 274.15 billion euros last week in six- and seven-day funds that expire on Wednesday.

But ahead of that expiry, the ECB lent only 229.07 billion euros earlier on Tuesday and means a 45 billion euros net drain in liquidity.  In addition, the ECB drained -- as targeted -- 59 billion euros in a one-week deposit tender on Tuesday to neutralise the effects of its government bond purchases, which also made good on a 27 billion euros shortfall in last week's sterilisation attempt. The total reduction of ECB liquidity on last week is 72.2 billion euros and contributes to the current final week of the June maintenance period for bank reserves.

If the trend in the weekly Main Refinancing Operations is sustained, the level of ECB excess liquidity provision over banks' structural funding needs would halve in July compared to 250 billion currently, said Lena Komileva, head of G7 market economics at Tullett Prebon in London.

It would also mean Eonia rates staying elevated and lift Euribor further, she said. The overnight EONIA rate EONIA= fixed at 0.405 percent onMonday.

The fact the ECB's one-week deposit tender today produced marginal/average rates of 0.75/0.56 percent respectively, compared with Euribor at 0.459 percent suggests higher rates in short-term maturities related to the ECB's exit strategy will continue to pull 3-month Euribor higher, Komileva said.

NO CHANGE TO RATE EXPECTATIONS But the higher Euribor and euro Libor rates are unlikely to bring forward the first ECB policy rate hike. The liquidity reduction was better than the market was expecting, and futures sold off as a result. A reduction of liquidity is part of the ECB's exit strategy, so I simply see this as a marker of progress rather than bringing forward a rate hike, said Peter Chatwell, market strategist at Credit Agricole in London.

The ECB next meets to determine interest rates on Thursday.A Reuters survey of economists indicates rates are likely to remain at 1.0 percent until the third quarter of 2011.

The fact that liquidity has been reduced also does not indicate ebbing stress in the banking sector. A significant amount of the one-year 442 billion euros which expired on July 1 was from strong banks playing the arbitrage. It's not at all clear that banking stress is easing, said Chatwell.