January 21, 2014 / 9:00 AM / 4 years ago

German two-year yields near six-week lows before ECB cash injection

* German two-year yields around six-week lows, below Eonia

* Rise in overnight rates intensifies talk of ECB easing

* ECB expected to inject 105 bln euros in one-week loans

By Marius Zaharia

LONDON, Jan 21 (Reuters) - German two-year bond yields hovered around six-week lows on Tuesday before a European Central Bank offering of short-term loans to banks that could intensify speculation of further policy easing.

The cash injection at 1015 GMT is under the spotlight after overnight bank-to-bank lending rates rose above the ECB’s benchmark refinancing rate of 0.25 percent, which usually caps short-term borrowing costs.

This is expected to create discomfort within the ECB, which wants to avoid a tightening of monetary conditions that could slow the economic recovery and potentially push inflation even further below its close-to-2 percent target.

ECB President Mario Draghi laid out two triggers for more monetary policy easing at the bank’s January meeting: a worsening of the medium-term inflation outlook or an unwarranted rise in money market rates.

Tuesday’s cash tender looks like a win-win situation for two-year German bonds.

The more cash banks take from the ECB, the less need for them to borrow from other banks, easing the upward pressure on overnight rates and keeping two-year yields low.

A small take-up would have the opposite effect on overnight rates, increasing speculation about further ECB easing later this year, potentially pushing two-year yields even lower.

Two-year German yields were flat at 0.175 percent, having hit a six-week low of 0.164 percent on Monday. Eonia, the euro zone overnight bank-to-bank lending rate, fixed at 0.359 percent on Monday.

“The more you have tensions at the very front end the more chances of the ECB delivering something. That’s why you see an inversion at the very front end of the curve,” said Patrick Jacq, rate strategist at BNP Paribas in Paris.

Two-year yields held steady despite Germany planning to sell up to 4 billion euros of two-year bonds on Wednesday. Ten-year yields rose 1 basis point to 1.75 percent.

Banks are expected to take 105 billion euros at the ECB’s offering of one-week unlimited loans, up from 94.74 billion euros in the previous week, according to a Reuters poll.

“We would expect a number well north of this, which should have a decent impact on where Eonia fixes,” Societe Generale rate strategists said in a note.

If the take-up is not much higher than the consensus, the impact on Eonia should be temporary and limited.

Excess liquidity in the euro zone banking system - cash beyond what banks need for day-to-day operations - last stood at just under 140 billion euros.

Having stood at a record of about 800 billion in mid-2012, it has been steadily falling as banks have repaid about half of the roughly 1 trillion euros in three-year emergency loans taken from the ECB in late 2011 and early 2012.

“There is clearly some risk that we are already approaching the limit where excess liquidity is not high enough ... to make liquidity flow smoothly,” Nordea analyst Anders Svendsen said.

“Either money market rates settle at a lower level soon or we could get new action from the ECB.”

Markets would also watch the ECB’s attempt to drain some 177.5 billion euros from the market at its weekly operation aimed at neutralising the effect of the bond purchases it made during the crisis. Failure to drain the entire amount would increase excess liquidity for the coming week.

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