Liquidity to keep market rates low after year-end

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Ample cash in the system should see euro zone money markets run smoothly over year-end and lending rates stay low in the first half of 2010 after the European Central Bank's next offering of 1-year money.

Even a modest take-up of funds at the ECB's likely final 12-month open market operation in December will ensure no shortage of cash in the banking system until at least June.

That should keep overnight rates pinned near record lows and enable the interbank market to continue its slow improvement.

Interbank lending rates, such as Libor or Euribor, typically tick higher at the end of the year as banks seek cash to help present their balance sheet in the best possible light.

Euro zone banks are replete with ECB funds, and the system is carrying around 60 billion euros more than the central bank deems necessary, most of it parked in its vaults overnight via the deposit facility.

Traders said one-week interbank rates which cover the year-end may be subject to a small premium with banks unwilling or unable to offer cash but they see no shortage of money.

"We've still got the deposit facility being used massively compared to historical year-end levels so there isn't going to be much of a squeeze," said Calyon rate strategist David Keeble.

And rates derived from overnight indexed swaps by BNP Paribas strategist Alessandro Tentori show only a small rise in rate expectations with OIS from the period December 28-30 at 0.42 percent and 0.57 percent from Dec 31-Jan 4.

One-week euro Libor rates jumped more than 50 basis points at the end of 2007 as the credit crunch began to bite, compared with around 11 basis points at the end of 2006.

Tender demand to decide rates
Looking ahead, demand at the ECB's tender of unlimited 1-year funds will dictate liquidity conditions moving into next year, but even a relatively modest take-up would mean excess funds in the system through the first half of 2010.

A Reuters poll this week showed banks are expected to help themselves to 125 billion euros at the tender.

There is already nearly 520 billion euros of 1-year money in the financial system, around 85 percent of the ECB's outstanding open market operations. None is due for repayment until a sizeable 442 billion euros at the end of June next year.

Assuming a 35 percent roll over rate at maturing 1-, 3- and 6-month operations until the December tender and around 50 billion euros remaining in 1-week money, demand of just 100 billion euros for 1-year money would leave an excess in the system close to current levels.

That, analysts say -- even without taking account of the additional liquidity provided by the ECB's covered bond buying programme -- should keep Eonia overnight rates pinned around 0.35 percent for several months, all else being equal.

"The liquidity squeeze, if you look at Eonia rates, will be in June/July next year when the first of the 1-year money matures and people are not sure what's going to happen," said a money market trader. He added there was about a 30 basis point premium on Eonia over the week when the 1-year funds mature.

Analysts said the excess liquidity in the first half of the year should also help money markets function. They have shown some signs of improvement with lending for up to 12 months but only to certain favoured banks.

"January should see things ease further as capital constraints lift after year-end," said Calyon's Keeble.

Using Bank of England figures on UK interbank lending as a proxy for euro zone interbank lending -- euro zone figures are not published -- outstanding amounts have risen more than a third since the start of the year.

But lending is still around two-thirds lower than levels seen in August 2008, when some banks relied on money markets for a large part of their funding.

Exit policy concerns
Markets are pricing higher rates in the second half of next year however, which may add to demand at December's tender, even though the European Central Bank may not restrict access to shorter-term liquidity as 1-year money matures.

The three-month OIS rate in 9 months time is 1.12 percent, and 1-year rates starting in 12-months time are at 1.77 percent, compared with 0.83 percent at the tender date, BNP Paribas said.

But much uncertainty remains over how the ECB will implement an exit strategy; anything other than a very gradual approach risks pushing interest rates sharply higher, analysts said.

The central bank is expected to give further details of its plans at a policy meeting next week but last week took what many analysts see as the first step towards the exit by tightening collateral rules on asset-backed securities.

"Everything the ECB has done so far has been in the guise of expansion, of getting liquidity into the market and widening the collateral base as much as possible," said ING rate strategist Padhraic Garvey.

"For the first time they've clawed some of that back so if you were to point to the beginning (of an exit), this would be it."