The euro zone interbank funding market reacted calmly on Monday to Europe's bank stress test results, and the absence of nasty surprises will see the European Central Bank continue to withdraw liquidity.
Such a move from the ECB would keep the upward pressure on euro money market rates, which grew after banks paid back 442 billion euros of one-year emergency loans to the ECB on July 1, wiping off a chunk of excess liquidity from the market.
The result of the stress test gives comfort to the ECB in terms of their exit strategy and so the market basically fixes the Euribor higher, expecting the money market curve to converge to a fair level at the end of the year, said Alessandro Tentori, strategist at BNP Paribas.
This means the overnight Eonia rate EONIA=, set at 0.5 percent on Friday, will creep up towards and even surpass the ECB's benchmark refinancing rate of 1.0 percent over time. A move up to 1.0 percent would signify a return to a more normal functioning market.
Eonia is a weighted average rate of all overnight unsecured bank-to-bank lending transactions. The three-month euro London interbank offered rate EUR3MFSR= edged up slightly to a fresh 11-month high of 0.66125 percent on Monday but the spread over the equivalent overnight index swap rate EUREON3M= -- a closely watched gauge of money market stress -- held steady at 24 basis points.
The ECB will probably draw comfort from the result that showed only 7 banks out of 91 failed, and continue withdrawing its extraordinary liquidity support introduced at the height of the financial crisis following the collapse of Lehman Brothers.
The stress tests didn't really impact the interbank markets to any great extent, said ICAP analyst Chris Clark, adding the forward markets, having factored in an improvement in money market stress levels last week, was little changed as well.
TRANSPARENCY While there are concerns the stress tests may be too lenient, analysts said they offered added transparency to the sector which could help restore confidence between some banks. The wholesale funding market is still closed to some financial institutions and analysts expect the weakest ones will continue to rely heavily on ECB support.
It's going to take time for people to work through the data and everyone wants to see 2Q results as well, said James Chappell, financial sector strategist at Olivetree Securities.
(The stress test is) not an instant fix and there still are issues that need to be dealt with, but it's a step forward.
One of the issues, market participants say, is Basel III, the new set of rules laying out how much capital banks need to set aside against their lending.
There is still a big uncertainty about what Basel III will require in terms of various new ratios like liquidity ratios and leverage ratios, said Christophe Nijdam, bank analyst at equity research firm AlphaValue.
As long as Basel III worries are not answered, for some of the euro zone banks, there will be some problems for them in the interbank market. (Editing by Ron Askew)