MONEY MARKETS-Short-term rates fall as banks hold on to ECB cash

Fri Feb 22, 2013 8:29am EST

* Eonia rates fall as banks pay back below-forecast 61.1 bln

* Money market curve flattens, euro falls after ECB data

* Post election Italian repayments may bring more volatility

By William James

LONDON, Feb 22 (Reuters) - Money market rates fell on Friday after a smaller than forecast repayment of European Central Bank loans boosted expectations that the banking sector would stay awash with cash for the foreseeable future.

The first early repayments of the second batch of three-year loans, made last year to shore up the euro zone's fragile banking sector, came in at 61.1 billion euros, well below the Reuters consensus of 130 billion euros.

The low repayment caused traders to push back their expectations of when the current massive cash surplus in the banking system will fall low enough to drive overnight interbank lending rates up.

Eonia rates fell and Euribor futures rose - both signalling expectations of lower rates - as the ECB announcement cemented the market's view that liquidity would remain high for the near term. Reuters data showed a surplus of 480 billion euros before the latest repayments.

"You see liquidity is coming out of the system slower than anticipated so you adjust expectations of where Eonia fixes," said Benjamin Schroeder, strategist at Commerzbank.

Longer-dated rates were hardest hit, with two-year Eonia , which represents the average overnight borrowing rate over the next two years, falling 4 basis points to 20 basis points.

"At the very short end of the curve you would always be very far away from the 150-250 billion euro threshold where Eonia fixing might start to react to low liquidity, so we should expect the effect to take place further down the road," Schroeder said.

The gap between one-year and two-year Eonia rates, which widened when initial repayments of the first batch of ECB loans came in higher than expected, was now back at 9 basis points -- matching levels seen before the Jan. 25 announcement.

This flattening of the money market curve caused the euro, which has become closely correlated with short-term interest rates since the loan repayments started last month, to fall to a six-week low.

VOLATILITY TO PERSIST

Although the two largest repayment dates have now passed, analysts expected the curve to continue to react to future weekly returns.

"It's going to be another two or three weeks till things settle down and we get the speed of weekly repayments. At the moment I think it's a bit too early to make judgments," said Simon Smith, chief economist at FXPro in London.

One of the prime drivers for this volatility could be the repayments from Italian banks, who borrowed heavily when the loans were made available but are believed to have only made small repayments so far.

The pace of Italian bank repayments could pick up once the country's elections, taking place on Feb. 24-25, were decided and banks had a clearer picture of the domestic outlook.

Based on this, Commerzbank recommended using the rally in Euribor rates as a chance to make bets for a re-steepening of the curve once Italian repayments start to kick in.