MONEY MARKETS-Short rates anchored; curve could steepen

* U.S. short rates anchored near zero; curve could steepen

* Euro zone money markets start to price in 3 rate hikes

* Portuguese bonds kicked out of repo basket

By Ellen Freilich

NEW YORK, March 25 (Reuters) – Short-term U.S. interest
rates held just above zero on Friday, anchored by the Federal
Reserve’s plan to keep those rates low for an extended period.

The U.S. central bank engineered its low short-term
interest-rate policy to encourage investors to invest in
longer-term securities and riskier assets and to prompt banks
to lend. The low rates were used as an antidote to the effects
of the financial crisis and to spur economic growth.

The Fed’s policy diminishes the incentive to remain in
short-term securities.

“There doesn’t seem to be much opportunity there,” said
Michael J. Materasso, head of fixed-income at San Mateo,
California-based Franklin Templeton, with more than $280.9
billion in fixed-income assets under management. “Short-term
rates are very low and very compressed.”

Short U.S. rates are unlikely to budge until the Fed begins
to unwind some of its monetary accommodation, Materasso said.

But depending on the extent of the unwinding, the yield
curve could get even steeper, he said.

If the Fed takes a lot of time to repo out the assets it
has acquired as part of the two phases of quantitative easing
— before it starts to raise the federal funds rate — and the
economy starts to do well, it risks raising inflation
expectations, Materasso said. Then long-term rates could rise
relative to short rates.

The amount of time the Fed takes to unwind accommodation
“will be very important” in determining the steepness of the
curve, he said. “We will get a much steeper yield curve if the
Fed starts raising rates 18 months from now, rather than 12
months from now.”

ECB EAGERNESS TO HIKE RATES PUSHES EURO ZONE RATES HIGHER

Euro zone money markets are on their way to pricing in
three interest-rate hikes this year, but short-dated government
bond yields paint a less-hawkish picture and may have room to
rise, analysts said.

With European Central Bank policymakers keeping up their
hawkish tone after indicating rates could rise as soon as
April, overnight indexed swaps for December’s ECB meeting
(ECBWATCH: Quote, Profile, Research) hovered around 1.68 percent on Friday.

All other things being equal, that reflects around a 70
percent chance of a third rate hike from the current 1.0
percent refinancing rate.

Two-year German government bond yields (DE2YT=TWEB: Quote, Profile, Research) —
which should also price in the additional risk of being
longer-term money — are also only around 1.7 percent.

That to some degree is the result of investors buying those
bonds as a safe haven from an uncertain geopolitical backdrop,
but they should move if the ECB fulfills analysts’
expectations.

Two-year German government bond yields are currently around
70 bps over the ECB’s refinancing rate, around the same level
as before the ECB’s last hiking cycle began at the end of 2005.
Once the ECB got going with its extended round of tightening,
the spread then widened to around 95 bps by mid-2006.

In 1999, by contrast, the spread was above 150 bps but
subsequently fell once the central bank started hiking rates.

“The two-year yield is telling us that the ECB is likely to
be more benign than money markets think,” said ING rate
strategist Padhraic Garvey.

In Asia, traders renewed bets this week that New Zealand’s
central bank would raise interest rates in the next 12 months
after briefly reducing them on concerns over the effect of
Japan’s massive earthquake on the country’s economy.

Money market rates in New Zealand and other major economies
have returned to levels prior to the devastating disaster that
hit Japan on March 11. Economists expect a limited impact on
global economic activity and central bank policies.

Some analysts thought the market reversal premature.

“It’s a very fluid situation,” said Michael Turner, RBC
Capital Markets’ fixed income and currency strategist in
Sydney.

MONEY MARKETS-Short rates anchored; curve could steepen