* Money market rates hit levels seen before July ECB meeting* Rate hike expectations brought forward by several months* Higher short-term rates may hinder euro zone recoveryBy Marius ZahariaLONDON, Sept 2 A steep increase in euro zone money market rates is raising questions about the effectiveness of the European Central Bank's promise to keep interest rates low for a long time. The ECB's unprecedented pledge in July was aimed at keeping a lid on money market rates, which were then rising on prospects of reduced global central bank liquidity, especially from the U.S. Federal Reserve. But, as with the Bank of England, economic news has stiffened financial market resistance to the ECB's efforts at forward guidance on policy. The words of ECB President Mario Draghi worked in bringing rates down for only a few days before forecast-beating euro zone economic data reversed the move. These tighter monetary conditions, exacerbated by international markets' efforts to second-guess the Fed, could eventually threaten the recovery. Money market rates up to one-year maturity have held steady in recent weeks and the curve relatively flat, showing the ECB is not expected to ease monetary policy further. Longer-term rates show money markets have brought rate hike expectations forward by three to six months, depending on how the shift is calculated.
"We can see through forward guidance now ... it just doesn't work when the economy is recovering," said David Keeble, global head of fixed income strategy at Credit Agricole in New York. The most common way to calculate when the market expects the first hike is based on the assumption that by the time the ECB raises rates, the excess liquidity in the euro zone - in decline as banks repay three-year ECB loans taken at the height of the crisis - would no longer weigh on money market rates. In normal liquidity conditions, the overnight Eonia rate would trade close to the ECB's key refinancing rate - now at 0.50 percent. Overnight Eonia is now around 0.10 percent. A rate hike would be fully factored in when forward Eonia, which reflects expectations of where Eonia will be in the future, reaches 0.75 percent. That point is now October 2015, compared with March 2016 before the July meeting.
"The bottom line is that no matter how you calculate them, market expectations have moved adversely," said Abhishek Singharia, European rate strategist at Deutsche Bank in London."Market rates have moved to a point where they price rates sooner than before (the forward guidance was introduced)."ECB REACTION After the ECB's August meeting, when money market rates were lower than they are today, Draghi said their rise was "unwarranted". However, Draghi's options to counter the market move are limited to verbal warnings, analysts said.
Draghi said the ECB had "extensive" discussions about a further rate cut in July, when the economy looked worse, but decided against one, making it harder to justify such a move as the economic outlook improves. Data last week showing stronger-than-expected German business sentiment and strong U.S. growth in the second quarter have increased confidence in the global economy, creating conditions for a further rise in short-term rates."Probably he (Draghi) will fight to some extent the rise in rates, but not very decisively," said Vincent Chaigneau, head of fixed income strategy at Societe Generale in Paris. One-year one-year Eonia rates, which reflect where one-year Eonia contracts are expected to be in one year's time, were last at 0.43 percent, almost 10 basis points higher than where they were on July 3, one day before the ECB meeting - running counter to the central bank's forward guidance. In August, the rate defied Draghi's warnings and rose a few basis points even as he spoke after the ECB policy meeting. Also confronted with the potential problem that rising short-term interest rates could choke the recovery, Bank of England Governor Mark Carney said on Wednesday more stimulus was on the cards if markets got ahead of themselves. But Draghi was not expected to be so aggressive."The ECB has always been more conservative in their approach than the BoE," Deutsche's Singharia said.