Bank-to-bank euro borrowing costs extended their march higher on Friday as the market repriced those rates following the recent drop in excess money market liquidity when 442 billion euros of one-year loans expired.
The three-month euro London interbank offered rate EUR3MFSR= rose to 0.76 percent, reaching highs last seen in September, and the three-month euro overnight index swap EUREON3M= climbed towards 0.6 percent, the highest in a year.
The European Central Bank successfully weaned banks off 442 billion euros of one-year emergency funds last week, but is continuing to provide unlimited short-term funds.
Overall, the ECB seems to be happy with the recent development, suggesting there will be no additional measures for the time being, Rabobank senior market economist Elwin de Groot said. We expect euribor and other short-term rates to gradually creep higher over the course of the year, and ultimately to reach the reference rate maintained by the ECB (1 percent) by early 2011.
Excess liquidity now stands at around 120 billion euros,well off levels above 330 billion euros seen before the expiry of one-year loans, BNP Parbas analysts said.
For now, this amount of liquidity is enough to keep the overnight Eonia rate well below the ECB's benchmark 1 percent rate. It was set at 0.398 percent EONIA= on Thursday, having dropped as low as 0.30 percent earlier in the year.
Eonia, however, looked set to climb further next week when the new reserve maintenance period begins on Wednesday.
Banks tend to store more cash than is required during the early stages of a maintenance period in order to avoid a last-minute dash for cash.
But when excess liquidity is just above 100 billion euros, (such bank) behaviour could lead to a fall in excess liquidity close to zero. This is the risk next week, BNP Paribas strategist Patrick Jacq said.
BASIS SWAP Meanwhile, euro basis swaps, which had been trending higher for many months, suffered a sharp reversal on Thursday and extended the fall on Friday, driven in part by a slowdown in corporate bond issuance and improved banking sector sentiment.
The two-year 3s6s basis swap fell to around 13 basis points from 19 bps and was well off the record high of about 21 bps set earlier in the year, according to ICAP.
A basis swap involves swapping two streams of floating interest rates, for example paying 3-month Euribor versus receiving 6-month Euribor.
The impression banks are becoming less stressed would at the margin push 3s6s lower, said Morgan Stanley rate strategist Laurence Mutkin.
But banking stress has not disappeared overnight nor is it the case that 3s6s should return to levels that prevailed during the pre-crisis period.
Traditionally there would be little difference between the two, with the 6-month swap rate roughly equal to a spot 3-month rate and a forward 3-month rate in 3-months time, the small difference -- the basis -- being the enticement to the lender to lend for six months rather than three.
But during the financial crisis which began in late 2007, six-month euribor rates moved sharply higher versus shorter-dated rates, leaving many borrowers not wanting to have their costs linked to longer-dated euribor rates. (Additional reporting by Kirsten Donovan; Editing by Susan Fenton)