* BoE keeps rates on hold, but hike still seen by May
* Quarter point hike almost fully priced
* In euro zone, Eonia tops one percent as liquidity dwindles
By Kirsten Donovan
LONDON, Feb 10 (Reuters) - Interest rate markets stuck to their view that the Bank of England would raise interest rates by Mayafter the BoE held fire on any policy changes on Thursday.
Most analysts were expecting the Bank to keep interest rates on hold at 0.5 percent, although some were pricing in a slim chance of a hike.
Speculation of a near term rise has gathered momentum due to expectations annual inflation will inch up, having already hit an eight-month high of 3.7 percent in December, almost twice the central bank's target.
Minutes of the BOE's January policy meeting also recorded a more hawkish tone with two members voting for a rate hike and investors have almost fully priced expectations of a quarter point move in May.
March gilt futures and short sterling interest rate futures fluctuated in the wake of the decision, briefly pushing slightly higher, before turning tail and trimming their early gains.
"The fact that short sterling traded a bit lower from where we were before the meeting suggests today's move was largely expected and there was a bit of profit taking," said Morgan Stanley rate strategist Laurence Mutkin.
"Now it's all eyes on next week's inflation report."
The quarterly update to the BoE's growth and inflation forecasts are released next week, although the bank's Monetary Policy Committee will have been privy to the information in it.
"The report is vital because we are pricing in nearly 100 percent chance of a rise by May's inflation report, so if this one is remarkably dovish, the market will have to reconsider," Mutkin said.
Forward overnight swap rates price in only an outside chance of a move in March, as they had done for this month.
BoE Governor Mervyn King has predicted inflation could near 5 percent in the coming months but said it remained on track to return to target early next year.
"Even if interest rates do rise in the near term, the likelihood is still that they will rise only gradually and remain very low compared to past norms," said Howard Archer of IHS Global Insight, adding that the group saw UK interest rates rising to only 2.0 percent by the end of 2012. Benchmark three-month sterling Libor rates GBP3MFSR= were fixed ahead of the meeting and edged up to 0.80500 percent.
EONIA TOPS 1 PERCENT In the euro zone, the Eonia overnight rate EONIA= jumped above the the European Central Bank's one percent refinancing rate at the start of the ECB's new maintenance period, after banks took less liquidity than expected at this week's cash tenders.
Excess money market liquidity has dropped around 60 billion euros to around 40 billion euros this week after banks scaled down their intake of one-week and one-month funds on Tuesday [ID:nLDE7170W4].
Despite the ECB dampening speculation of a near-term rise in official rates by saying last month's larger-than-expected jump in inflation had not altered its medium-term assessment, the market is currently pricing in more than 75 basis points by year-end, according to ING.
Many said that this seemed overdone at the present time.
"Certainly, rate increases are coming and the ECB seems comfortable that the market has now realised that this is the case," said Societe Generale's European economist James Nixon.
"However, if inflation is not an urgent and present danger and activity is slowing, we suspect the ECB would still prefer to defer rate increases if only to give Europe's banks and sovereigns more time to sort out their problems."
Benchmark three-month euro Libor rates EUR3MFSR= were little changed at 1.048 percent.