LONDON Dollar Libor rates were steady on Tuesday as Federal Reserve officials met to assess their controversial bond buying program against a backdrop of fresh tax cuts that could lift U.S. economic growth.
The central bank is not expected to signal any shift away from its intention to buy $600 billion in government debt but markets are already bringing forward expectations of when the Fed may start to raise interest rates.
Eurodollar futures fell to three-month lows this week and two-year Treasury yields are at their highest level in five months.
"We think the increase in Fed hike expectations is overdone, the market has priced in a possibility of hikes as early as the second half of 2011," Barclays Capital strategists said.
"The FOMC is likely to reiterate its message of extremely easy policy ... and that could be a catalyst for reversal of some of the recent outsized moves."
Dollar funding costs are easing meanwhile as year-end strains in money markets ease. Benchmark three-month dollar Libor rates were little changed at 0.30188 percent, near their lowest level this month.
Funding costs had increased in recent weeks as banks and companies from the euro zone's highly indebted nations paid-up to secure cash as worries about financial stability grew again.
Five-year euro/dollar cross-currency basis swaps -- which show the rate charged when swapping euro interest payments on an underlying asset into dollars -- eased to 38 bps from recent extremes of -41 bps, but that is still elevated compared with -21 bps at the start of November.
EURO BANKS TAKE LESS ECB CASH
Euro zone banks reduced their weekly funding at the European Central Bank by around 9.5 billion euros on Tuesday, which traders said reflected the trend for banks to front-load their central bank reserve requirements during each maintenance period.
"There were some banks building up their reserve requirements last week but front-end rates are easing now and we'd expect them to come in softer at least until the end of the year, when we may see some aggressive spikes just because people will be restricted in what they can lend," said one trader.
The Eonia overnight rate has eased to 0.587 percent from 0.738 percent at the start of the current period and Morgan Stanley see it falling to 0.4-0.45 percent next week as technical factors increase the amount of excess liquidity in the banking system to around 100 billion euros.
The next test of banks' ability to stand on their own feet comes on December 23 when 200 billion euros of maturing 6- and 12-month funds must be repaid.
The ECB has however pledged to carry on providing unlimited funding until at least mid-April with banks, particularly in Ireland still heavily reliant on the liquidity provision. Spanish banks borrowed 64.5 billion euros from the ECB in November, down from 71 billion in October.
ECB sources said it was considering requesting a capital increase to help cope with the rising costs of fighting the euro zone debt crisis after it stepped up the pace of government bond purchases last week.
"They're buying a lot more bonds than they thought they were going to have to and it makes sense to provision against any kind of losses they could make," Credit Agricole rate strategist Peter Chatwell said.
Benchmark three-month euro Libor rates were a fifth of a basis point lower at 0.95313 percent.
-- Additional reporting by William James