Markets shifting but may still be too hawkish on ECB

By Kirsten Donovan

LONDON (Reuters) - Financial markets are beginning to unwind expectations for further euro zone rate rises after this month's European Central Bank hike but should probably go further as the threat of euro zone recession looms larger.

After talking tough on inflation for months, the ECB raised rates by a quarter point to 4.25 percent earlier in July, their highest in seven years.

The move was designed to contain inflation, which soared to a record 4.0 percent in June -- more than double the central bank's target -- due to rising oil and food prices.

ECB President Jean-Claude Trichet is sticking to the bank's recent "no bias" line about future policy moves and markets are less sure the ECB will tighten policy again in the face of slowing growth. But analysts say they are still too hawkish.

Figures derived from Eonia overnight rate contracts show the market pricing around a 60 percent chance the European Central Bank will raise rates to 4.5 percent this year.

That itself is a considerable unwinding of rate expectations given the figures -- which take spot Eonia rates and adjust them to forward rates that match the ECB's rate cycle -- were pricing in as much as three rate hikes this year as recently as June.

But the spectre of recession, as opposed to too-high inflation, may change assumptions further.

"It's not necessarily that people are starting to price in an easing, but if the ECB hike again, that may be seen as a mistake," Nomura rate strategist Sean Maloney said.