MONEY MARKETS-Short-term rates could ease further as ECB looms
* Money market curve could flatten post-ECB
* Traders alert to ECB assessment of early LTRO repayment
By Emelia Sithole-Matarise
LONDON, Feb 5 (Reuters) - Money market rates could ease anew this week with traders braced for potential verbal intervention from the European Central Bank on Thursday to calm markets jarred by banks' early repayment of ECB crisis loans.
Bank-to-bank lending costs rose sharply in January, led by longer-term rates as banks repaid at their first chance last Wednesday a bigger-than-forecast tranche of three-year loans which the ECB handed out in late 2011 to avert a credit crunch.
While the rates have eased back after banks on Friday said they would hand back a fraction of what the market expected at the second of such repayments, longer-term rates remained elevated on uncertainty of how speedily excess cash could be drained from the market over the year.
The repayments are viewed as a sign of healing in parts of the region's banking sector but the spike in rates is seen as a de facto tightening of ECB policy which spurred the euro to a 15-month high last week.
Focus is now on the ECB's monthly monetary policy meeting on Thursday which is expected to keep official interest rates unchanged with the spotlight on President Mario Draghi's assessment of the initial repayments and their impact on money markets.
"The Eonia curve is being shaped by expectations of future repayments so if he says he still doesn't see Eonia fixings being massively influenced by subsequent repayments in the LTRO, that could cause a little bit of flattening of the curve," a money markets trader said.
One-year Eonia rates - which reflect what overnight bank-to-bank lending rates are expected to average out over the year - were last around 0.20 percent, having risen as high as 0.25 percent last week before Friday's second bank repayment of the LTRO cash.
Three-month Euribor rates, traditionally the main gauge of unsecured bank-to-bank lending, were unchanged at 0.233 percent with equivalent Libor rates, set by a smaller panel of banks in London, also unchanged at 0.15429 percent.
The benchmark three-month Euribor rate is still near its highest level since September hit after the ECB announced on Jan. 25 that banks would repay early 137 billion euros in long-term loans - a move that has driven down excess liquidity in the financial system to around 484 billion euros.
Yields on German two-year bonds, the euro zone's most liquid debt and the safe-haven of choice in the region in times of market strain, also rose sharply last month before falling back.
"Whenever there was a big back-up in core rates eventually you had an active feedback into the peripheral countries because those highly leveraged countries cannot afford to have higher rates in a gradual recovery scenario," said Elaine Lin, a strategist at Morgan Stanley.
"We're quite cautious given the sell-off at the front end and if the ECB tends to be comfortable with such pricing in front end core yields you may have again an active feedback loop in the peripheral sovereigns, ie Spain and Italy."
The central bank has already flagged the bank's sensitivity to a too rapid withdrawal of liquidity last week. ECB Board member Peter Praet said the ECB would be vigilant to "ensure that overall liquidity in money market will remain consistent with the degree of accommodation that the current outlook for prices and real activity warrant".
In total, the ECB pumped more than 1 trillion euros into the banking system with two offerings of three-year loans in December 2011 and February 2012.
The heavy oversupply of ECB cash has long depressed the rates banks charge each other on lending markets, but a further significant repayment, expected on February 28, could drive rates higher.
"We expect the ECB to calm the aggressive market expectations on the short rates, as this could have negative implications on the real economy via the increase in the Euribor rates and the appreciation of the euro," Barclays Capital strategist said in a note.