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Rising euro, market rates not a one-way bet after New Year

By Emelia Sithole-Matarise and Anirban Nag

LONDON, Dec 18 (Reuters) - Short-term market interest rates and the euro have risen recently but some market prices suggest the move could lose steam in early 2014 as seasonal factors fade and the European Central Bank clarifies its next policy steps.

The euro has surged to a two-year high on a trade-weighted basis since the ECB's Dec. 5 meeting, at which it indicated it was in no hurry to cut rates further. Overnight lending rates, which feed into rates affecting transactions across the wider economy, have spiked in the same period and hoisted benchmark interbank rates to 15-month highs.

Short-term money market rates were already climbing before the ECB meeting, as the repayment by banks of three-year emergency loans extended by the central bank two years squeezes the amount of excess cash in the system.

The moves also reflect banks repatriating and hoarding cash to shore up balance sheets before year-end and in preparation for next year's ECB review of their financial health.

A sustained rise in interbank lending rates and the euro could hurt euro zone exporters and threaten the bloc's fragile economic recovery. But some market trends suggest further rises in 2014 are not a one-way bet.

Although forward euro zone overnight Eonia rates for dates covering future ECB meetings have risen up to 8 basis points since late November, to 0.15-0.17 percent, they are still below the spot Eonia rate, which fixed at 0.21 percent on Tuesday.

When forward rates trade lower than the spot rate it is usually a sign that the market expects looser ECB policy.

"The (Eonia) curve has flattened in the money market quite significantly and this probably suggests they are expecting some kind of measures from the ECB next year," said Alexander Wojt, a fixed income analyst at Nordea.

"Short end rates will keep rising but could revert quite quickly after year-end," he said, adding Eonia rates could move back to around 0.10 percent.

While many in the market expect the ECB to ease policy further next year, it is unclear how it will do so.

It could cut its main interest rate further from a record low 0.25 percent, or take its overnight deposit rate below zero, effectively charging banks to park cash overnight at the ECB.

That in theory should encourage them to seek a return on their money by lending more to businesses and households but policymakers at the bank are concerned that a negative deposit rate could have unintended consequences and erode interbank lending further.

The ECB could also offer banks more cheap long-term loans, although policymakers worry they would use the cash to buy high-yielding government bonds, as they did with the 1 trillion euros of three-year loans it provided in late 2011 and early 2012.

ECB President Mario Draghi wants any new loans to be tailored towards reviving lending to the broader economy, similar to the Bank of England's Funding for Lending Scheme, which aims to channel funding to small and mid-sized firms.


EURO VULNERABLE

Policymakers have shown little urgency to take steps to subdue money market rates and the euro. Draghi said this week the ECB would act if inflation stays low for too long and threatens the recovery but declined to say what instruments it could use.

But a decision by the U.S. Federal Reserve to start scaling back its monetary stimulus, which could come as early as Wednesday, could force the ECB's hand if it triggers an aggressive move up in short-term money market rates.

Currency markets also signal that the euro's rise may lose steam. In the options market, while near term euro/dollar risk reversals are indicating a smaller bias for euro weakness, in the longer term, they are showing a bias for a sustained drop.

In other words, while the one-month euro/dollar risk reversals are showing less demand for euro puts, or bets it will weaken, at the longer end, like the one-year , demand for such bets are gathering momentum.

"After the year-end we may see an end to the tightening but that does not mean short-term rates will come down," said Geoffrey Yu, currency strategist at UBS. "This will cap the euro's rise."

A number of banks, including Credit Agricole, BNP Paribas and Morgan Stanley, are in fact recommending investors to short the euro against the dollar at current levels of around $1.38.

Their recommendations are based on expectations that the Fed will start to rein in its bond-buying while the ECB will have to loosen monetary policy sooner rather than later.