Euro zone yields hold near lows before ECB meeting

Thu May 8, 2014 3:39am EDT

* Bond yields steady near recent lows

* ECB widely expected to leave monetary policy unchanged

* Spike in Eonia rate spike keeps alive chances of ECB easing

By Marius Zaharia

LONDON, May 8 (Reuters) - Euro zone government bond yields held close to recent lows on Thursday as a spike in money market rates kept alive an outside chance of the European Central Bank easing monetary policy further at its meeting later in the day.

None of the economists polled by Reuters expected the European Central Bank to make any move in May, a Reuters poll showed last week.

However, dwindling spare cash in the banking system has increased volatility in money markets in recent weeks. On Wednesday, overnight bank-to-bank Eonia rates settled at 0.26 percent, a touch above the ECB's main refinancing rate.

ECB President Mario Draghi has flagged "an unwarranted" rise in money market rates as a potential trigger for monetary policy easing, without pointing to any specific level of rates.

Analysts say the central bank would want overnight rates to trade within the zero to 0.25 percent band defined by its deposit and refinancing rates as otherwise its monetary policy becomes less efficient.

The rates which banks pay to borrow cash in money markets are being transferred onto businesses and consumers, thus a significant and lasting rise in interbank rates would be the equivalent of policy tightening.

This could slow down the euro zone's economic recovery and cap inflation, already running well below the ECB's target at just 0.7 percent.

"The wild card is what the ECB thinks of Eonia rates surging yesterday," said Suvi Kosonen, an analyst at Nordea. "Volatility is not the ECB's friend and the central bank has an option to ease the liquidity situation already today."

German 10-year Bund yields, the benchmark for euro zone borrowing costs, were flat at 1.475 percent, just off 11-month lows. Other euro zone bond yields were flat to slightly higher, with Spanish, Irish and Italian yields keeping close to the record lows they hit earlier this week.

The trend in lower yields has been supported this year by expectations that the ECB will eventually move to tackle low inflation. Half of the economists polled by Reuters expected some form of policy easing by the end of the year.

Such expectations should ensure debt sales of up to 4.5 billion euros in Spain and 750 million euros in Ireland go smoothly on Thursday.

CASH DRAIN

Kosonen said rate cuts were unlikely, but the ECB could suspend its weekly deposit tenders through which it drains money from the banking system to neutralise the impact of the bond purchases it made at the height of the euro zone debt crisis.

The tenders were introduced to quell concerns that bond buying was direct financing of governments, something the ECB is not allowed to do. A suspension, rather than a cancellation, may not pose legal obstacles, analysts said.

Such a move would release 167.5 billion euros into the banking system, a sum equal to the outstanding amount of bonds the ECB bought under its defunct Securities Markets Programme.

Other analysts said the volatility in Eonia rates would only be a concern for the ECB if it filtered through to short-term bond yields, which was unlikely given that markets continue to see a chance of further easing.

German two-year yields were last trading at 0.15 percent, well within this year's 0.07-0.27 percent range.

"The ECB will continue to show its willingness to fight inflation and that will keep short-term yields low. The volatility (in Eonia) should not be a concern for the ECB right now," said ING rate strategist Alessandro Giansanti. (Reporting by Marius Zaharia; Editing by John Stonestreet)

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