By Kirsten Donovan
LONDON, Aug 11 (Reuters) - A bit more optimism from the European Central Bank's chief and signs of improvement in euro zone and U.S. economic data have led money markets to bring forward bets for a first rise in euro zone interest rates.
The ECB's Jean Claude Trichet last week hinted growth could return to the euro zone economy sooner than previously thought.
Figures derived from widely-watched market rates show traders now expect the ECB to raise rates by a quarter of a percent to 1.25 percent in June 2010 to stave off inflationary pressures as the economy emerges from the recent downturn.
That contrasts with market expectations over the last two months that the ECB would leave rates unchanged through most of next year given banks still seem reluctant to lend to firms and households despite huge liquidity injections.
The swing in expectations has raised forward swap rates -- fixed rates which people are willing to pay to receive floating-rate payments over pre-agreed time frames -- quickly this month as investors lock in fixed rates.
"(One-year forward one-year swap rates) have risen as the prospect of eventual policy tightening became less unimaginable to players," said Morgan Stanley strategist Laurence Mutkin.
These rates show that the average euro zone policy rate for
the year starting in one year's time is expected to be at 2.7
percent
Similar trends are seen in the U.S. and UK: forward rates
are also showing average rates of 2.5 percent in the U.S.
WATERSHED?
The spread between the one-year forward swap rate and the one-year swap rate starting now is also a key indicator of shifting interest rate expectations.
It has widened around 65 basis points in the last month to 138 basis points. In the past decade, a spread of around 90 basis points has signalled a likely end to an ECB easing cycle.
"The ECB will not be in a hurry to signal a shift towards an exit strategy," said Lena Komileva, head of G7 market economics at Tullett Prebon.
"But signs of a transition point in the global economic cycle and strong investor sentiment in risk markets are set to place ongoing pressure on forward rate contracts."
That pressure, which reflects the view that higher rates are ahead, is eminating from the very front of the yield curve -- where the ECB is now flooding markets with short-term money.
The 200 billion euros or so of excess liquidity in the
system is flowing back to the ECB's overnight deposit facility
and keeping overnight rates
But as the health of money markets improves, banks are likely to rely less on the ECB's open market operations and scale back their appetite for short-term funds.
"The impact of that is that you could start to see a good chunk of money currently in the deposit facility being used up and that would put upwards pressure on Eonia and upwards pressure on Euribor," said rate strategist David Keeble.
Current three-month Eonia rates
The three-month Euribor/Eonia spread should also as a result narrow further from 40 basis points now. Three-month Euribor interest rate futures contracts <0#FEI:> last week posted their biggest weekly fall in two months, pushing implied yields almost 20 basis points higher on contracts to December 2010.
TENDER TO OFFER MORE INSIGHT
The ECB's second ever tender for one-year money in September will offer more of an insight into the central bank's thinking.
The ECB is committed to providing as many funds as banks want but it reserves the right to add a spread over the 1 percent rate at which it has recently been providing money.
"The market is ... seeing a halt in the decline of Libor fixings and then the possibility the ECB may add a spread at the next 1-year tender is elevating rate hike expectations," said BNP Paribas strategist Alessandro Tentori.
Analysts are split on what the ECB will do as another huge take-up of funds of the sort seen at its first one-year tender in June would limit the effectiveness of any future rate hikes.
"It's a classic dilemma," said Christoph Rieger, Dresdner Kleinwort rate strategist.
"If they don't introduce a spread, the risk is that banks will take again a lot of cash. But if they do introduce a spread it could be counterproductive because Euribor fixings would be at risk of surging higher and greater rate hike expectations would induce banks to bid for more not less one-year funds."