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Rising euro zone money rates set to support euro
A "normalisation" of money markets, involving withdrawal of some of the vast amount of excess liquidity that the European Central Bank had pumped into the banking system, would naturally lead to a rise in money market rates, although the central bank seems to be aiming to keep disruption to a minimum.
Traders cited a rise in euro zone market rates as one factor in the euro's run-up late last week. The euro has risen some 10 percent against the dollar since June as speculative players have reduced bets the single currency will fall further as concerns about euro zone sovereign debt have eased.
The euro hit a 10-week high of $1.3029 on Monday, after falling to $1.1875 in early June, its lowest since 2006. It eased to around $1.2820 on Wednesday.
At the same time, three-month euro Libor rates have been steadily rising, and were at 0.81438 percent on Wednesday, up from 0.71750 percent at the start of the month.
In the past two days, the euro's gains have tapered off as investors have turned cautious ahead of the results of European bank stress tests due out on Friday.
"The euro is likely to be in range trading in the near term" said Kenneth Broux, market economist at Lloyds TSB, with the single currency capped near $1.30 and supported near $1.2750.
By contrast, U.S. money market rates have fallen as demand for dollars has diminished and as weak U.S. economic data has raised speculation the Federal Reserve may have to ease policy further.
Three-month dollar Libor stood at 0.50625 percent on Wednesday, compared with 0.53331 at the start of July.
"There seems to be an oversupply of dollars now as credit concerns ease" one money market trader said.
EURO MARKET RATES FIRM
Like many other major central banks, the ECB injected massive liquidity into the banking system after commercial bank-to-bank lending seized up in the wake of the 2008 collapse of Lehman Brothers.
But the expiry of 442 billion euros of 12-month emergency loans on July 1 caused the level and duration of excess liquidity to drop, with banks reducing their dependency on the ECB and looking to bank-to-bank markets for funding.
As a result, benchmark interbank rates have firmed, and seem likely to rise further as the ECB gradually phases out liquidity operations.
"It's pretty clear that the ECB is fairly sanguine that the current problems in the banking sector will get ironed out and they want to prepare the ground for an exit strategy by the end of this year or early next year" said Nick Stamenkovic, strategist at RIA Capital Markets.
An exit from extraordinary liquidity measures should see the unsecured overnight Eonia rate rise to around the ECB's 1.0 percent refinancing rate, with benchmark euribor rates slightly higher.
ECB Governing Council member Ewald Nowotny told Reuters in an interview published on Wednesday: "We don't see this as something disturbing."
"I see this as an element of normalisation because - in the amount as we have it now - it is a sign of functioning money markets."
Market participants also say the results of stress tests on 91 European banks would not alter the long-term trend towards higher money market rates.
They were cautiously optimistic the tests would not reignite fears of counterparty risk between banks, leaving the ECB's exit from liquidity provision as the main driver behind rising rates.
Meanwhile, minutes from the U.S. Federal Reserve's rate-setting meeting last week showed policymakers were ready to take additional easing measures after it cut growth forecasts.
That, in addition to weak economic data which pointed to risks of further slowdown, pushed the yield on two-year Treasury notes to a record low of 0.5764 percent on Tuesday, further undermining the dollar's appeal relative to the euro.
Fed Chairman Ben Bernanke is expected to say interest rates will stay low when he testifies in Congress this week.