Liquidity squeeze set to apply pressure on short-term bond yields
* ECB one-week lending drops, falls below forecast
* Excess liquidity set to shrink after LTRO repayments
* Money market pressure tipped to push up short-dated yields
* Long-dated bond yields edge higher in light trading (Updates prices)
By John Geddie
LONDON, July 22 (Reuters) - Short-term bond yields could follow European money market rates higher this week as a drop in spare cash in the euro zone banking system takes effect, market analysts said on Tuesday.
Banks took a lower-than-forecast amount of one-week loans from the European Central Bank on Tuesday, compounding a squeeze in excess liquidity set to bite when banks repay a bumper 21 billion euros ($28.3 billion) of emergency loans (LTROs) on Wednesday.
Market strategists say depending on other special factors such as bond expiries, tax payments and holidaymakers taking cash out of the system, excess liquidity could fall below 100 billion euros for the first time since May - before the ECB took new measures to relieve strains in money markets.
"We expect to see some short-term volatility," said Orlando Green, European fixed income strategist at Credit Agricole.
The euro overnight interbank lending rate edged up to 0.048 percent on Monday, the upper end of the 2 to 5 basis point range it has traded in during the last month. Green at Credit Agricole predicts it will move higher, breaking out of that range, over the next days.
Two-year yields in Germany - the benchmark for euro zone borrowing - edged up 1 basis point to 0.04 percent on Tuesday, and some strategists say these short-dated bond yields should also track money market rates higher.
Commerzbank strategist Rainer Guntermann said this week's LTRO repayment is a direct result of the ECB's decision last month to charge banks to keep their money in overnight deposits.
"You can't force banks to lend," he said, pointing out that it will take time for policymakers to achieve their goal of forcing money out of the financial system into the real economy.
The ECB tried to ease a potential liquidity squeeze last month by terminating its weekly deposit tender to neutralise the effect of its crisis bond purchases, but the effects of this injection have already faded.
Excess liquidity was last 125 billion euros, dropping from nearly 170 billion euros at the end of last month.
The combination of a net drop in ECB one-week lending by 2 billion euros and the 21 billion euro LTRO repayment should alone push excess liquidity near 100 billion euros on Wednesday.
However, with the European Central Bank set to offer its first tranche of new targeted long-term loans in September, few strategists think this liquidity squeeze will become systemic.
Elsewhere, longer-dated government bond yields edged up slightly across the single-currency bloc on Tuesday amid light summer trading volumes.
Traders said the slight underperformance came as the market digested 6 billion euros of new debt sales in the form of 10-year Belgian bonds and 30-year bonds from the European Financial Stability Facility, while some investors were sidelined due to the geopolitical tensions in the Middle East and Ukraine.
German 10-year bond yields were 3 bp higher at 1.17 percent, as were most other core euro zone government bonds and the lowest-rated bonds in Portugal and Greece.
Spain and Italy saw their yields rising 1 bps to 2.58 and 2.78 percent, respectively. ($1 = 0.7417 Euros) (Editing by Catherine Evans)