Two-year German yields near zero as ECB injects cash

Tue Jun 17, 2014 7:44am EDT

* Two-year German bond yields near one-year lows

* Banking sector gets ECB liquidity injection

* Analysts see slow healing process in money markets (Updates with ECB liquidity tender)

By Marius Zaharia

LONDON, June 17 (Reuters) - German two-year bond yields held near one-year lows on Tuesday as the European Central Bank released tens of billions of euros into the euro zone banking sector, anchoring short-term interest rates around the zero bound.

For the first time the ECB did not hold a weekly deposit tender to neutralise the effect of the bond purchases it made at the height of the crisis, effectively injecting back into the market the 108 billion it drained last week.

That was partly offset by banks taking less in one-week loans than last Tuesday at the ECB's regular offering of unlimited cash - 98 billion euros compared with 137 billion - but still represented a significant cash injection.

German two-year bond yields were a tad higher on the day at 0.037 percent, still close to the 0.027 percent hit on Monday, which was the lowest since the end of May 2013.

"We could see two-year yields dipping into negative territory," said ICAP strategist Philip Tyson, adding however that it would be only a temporary phenomenon as investors would eventually sell two-year bonds for longer-dated debt or paper from other issuers to get a positive return.

Germany and the Netherlands sold treasury bills at a negative yield on Monday, the direct result of the ECB cutting the rate it offers banks to keep their money in overnight deposits to minus 10 basis points.

The ECB's move is effectively penalising banks for not putting money to work. Negative T-bill yields means governments will pay investors back less than they borrowed when the paper comes due.

Policymakers hope negative rates in time will force money out of the financial system and into the real economy. But some analysts remain pessimistic.

"If you don't want to lend money to businesses because you don't trust the economic viability of companies you will not do it, no matter what incentives you get from the central bank," said Marius Daheim, chief strategist at Bayerische Landesbank.

"The credit channel is blocked ... People don't trust the economy because growth is feeble, inflation is low, household debt is pretty high and unemployment is high as well."

FRAGMENTATION

The fact that banks reduced their take-up by 40 billion euros just as the ECB released almost three times that sum into the market shows the euro zone banking system remains somewhat fragmented.

It means the ECB's cash withdrawals had mainly been funded by the higher-rated banks in the euro zone's healthier states, while lower-rated peripheral banks remain reliant on ECB liquidity. At the same time, money fails to flow smoothly from the core banks to the peripheral banks.

"That's been to various degree the issue of the interbank market since the Lehman crisis," said Simon Smith, chief economist at FXPro.

Negative deposit rates might in the future help reduce fragmentation, in a process that will lead to smaller ECB liquidity injections, shrinking the banking sector's spare cash and keeping money market rates positive.

"Some banks, maybe a small percentage, may decide to lend a bit more to the periphery. But we're talking about months, quarters, maybe a year," said Elwin de Groot, market economist at Rabobank. (Editing by Nigel Stephenson)