Money markets euribor rate falls, pace of decline seen slowing

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* Euribor rates fall to lowest since Sept 2010* Prevailing risks could slow the pace of decline* Eonia rates have further room to fallBy Ana Nicolaci da CostaLONDON, March 12 Euribor interbank lending rates fell on Monday, under pressure from European Central Bank liquidity in the system, but the pace of decline may slow as economic fundamentals come back into play in influencing the level of short-term interest rates. Three-month Euribor rates fell to their lowest since September 2010 at 0.88 percent, edging closer to a record low of 0.63 percent hit in March of 2010. The excess liquidity in the financial system from 3-year ECB injections totalling 1 trillion euros ($1.3 trillion) could easily take Euribor rates to new record lows this year, said Simon Peck, rate strategist at RBS, but event risks may hinder the pace of decline."In many respects, we are now moving away from liquidity fundamentals ... we have got this very strong link between bank and sovereign risk so I don't think it's a pure liquidity story any more," Peck said. He expected the market to price Euribor rates of below 0.60 percent in the third quarter of this year, but added "we may see some resistance before we get that low."

The ECB's cheap 3-year loans since December have kept short-term interest rates under pressure. But the expectation that this will be the last such cash injection has put the focus back on economic fundamentals, with many saying the ECB's efforts has done little to resolve the region's underlying solvency problems, while its austerity drive could choke much needed growth. Market prices suggested the spread between forward rate agreements and overnight rates - a forward-looking indicator of counterparty risk - would tighten further, implying lower risk. But Peck said he was betting against the pace of the implied tightening, pointing out the various catalysts which could cause funding conditions to deteriorate again, including Greek elections next month."Our 2-year/2-year forward FRA/OIS widener continues to provide attractive risk/reward as a blow-out trade," he said.

Barclays Capital also expects some slowdown in Euribor's declining trend over the next months, given the scale of the recent move and after the ECB cemented expectations it will remain on hold for a while at its monetary policy meeting last week. The ECB kept interest rates at a record low of 1 percent for a third month running, but delivered a surprise warning on inflation."We expect the 3-month fixing to move to the 70 bp (0.7 percent) area by mid-June with the bottom likely at 65 bp (0.65 pct) by mid-summer," Barclays strategists said in a research note.

HOW LOW CAN YOU GO? Overnight Eonia rates traded at 0.36 percent on Friday, up from 0.359 percent in the prior session, but analysts say they too had further to fall even though some saw a floor at 0.25 percent - the level of interest offered at the ECB's overnight deposit facility."A number of small banks are probably still in the market and the fact that they are being charged higher prices creates a distortion in the calculation of Eonia, thus preventing the fixing declining further," the Barclays strategists said."Over time, the abundance of liquidity is likely to push this rate lower eventually."The rate could move to between 0.25 percent and 0.35 percent over the next three to six months, Laurent Fransolet, head of European fixed income strategy at the bank said. RBS's Peck said he saw Eonia rates easing to low-mid 30s over the next several months and remaining there for some time."In my view, there is a considerable probability that the market can move towards pricing in a deposit rate cut, and in this scenario, fixings could fall to 20 bps."The idea is that this would stimulate banks to lend money on rather than depositing cash with the ECB, he added.