LONDON, June 21 (Reuters) - Financial market stress eased further on Monday as investors cheered Beijing's vow to make its currency more flexible, but interbank euro funding costs rose again with excess money market liquidity set to drop.
A closely watched gauge of financial system stress, the two-year U.S. swap spread USD2YTS=RRUSD2YTS=TWEB slid to 31.0 from 33.5 on Friday, hitting its lowest level since mid-May.
For the markets, China's move towards currency flexibility will be taken as a vote of confidence in the global recovery and in the stability of international financial markets, said Lena Komileva, Head of G7 Market Economics at Tullet Prebon.
The rise in euro funding costs, however, showed no signs of running out of steam as banks prepare to pay back 442 billion euros of one-year loans to the European Central Bank on July 1.
That is expected to push up short-term rates, which have been artificially compressed by the ECB's liquidity provision.
It's still a big risk and some people are hedging their bets. One thing is for sure, excess liquidity will be noticeably smaller, said Christoph Rieger, strategist at Commerzbank in Frankfurt.
The benchmark three-month euro London interbank offered rate EUR3MFSR= climbed to 0.66438 percent from 0.66125 percent, reaching its highest level since late December, while the equivalent euribor rate EURIBOR3MD= was fixed at 0.733 percent, a high last seen in October.
Rather than it being caused by rises in risk aversion this move seems to be a function of reduced liquidity, said analysts at Credit Agricole.
The three-month euro Libor/OIS spread EUREON3M=EUR3MFSR= -- a gauge of money market stress -- narrowed to 17 basis points, the tightest since early May. The move was driven by a 4.6 basis point jump in the Overnight Index Swaps -- the biggest rise in a year -- to 46 basis points.
In contrast, sterling Libor rates were little changed a day before Britain's coalition government unveils its emergency budget which is expected to be the tightest in 30-year years.
Meanwhile, Chinese interest rate swaps fell as investors hoped a more flexible currency would mean less urgency to tighten monetary policy by raising interest rates.
The spot yuan CNY=CFXS climbed to its highest versus the dollar since its revaluation five years ago, with the Chinese central bank tolerating broad gains after ditching the currency's two-year peg to the dollar over the weekend.
(Additional reporting by Umesh Desai in HONG KONG, editing by Mike Peacock)