ECB cash in high demand despite low rates

LONDON: Euro zone banks are likely to continue to bid heavily for European Central Bank cash at tenders this week, seeking the comfort of extra liquidity in case Greece's debt crisis deteriorates.

Greek lawmakers were debating a package of fresh austerity measures on Monday, which must be passed later this week to secure additional aid funds urgently needed to avoid a default.

Fears that a Greek default could freeze interbank markets have caused a rush for funds at the ECB's unlimited cash tenders in recent weeks, sending excess liquidity in the banking system to a four-month high of over 71 billion euros last week, according to Reuters data.

The excess liquidity pushes euro interest rates way below the ECB's 1.25 percent refinancing rate, with Eonia fixing at 0.858 percent on Monday. In theory, when Eonia is lower than the benchmark rate, demand for ECB cash falls.

In comparison, Eonia fixed at around 1.3 percent before last week's seven-day tender.

However, daily Eonia volumes have also been falling, averaging around 25 billion euros in June, twice the levels recorded in April, pointing to reluctance by banks to lend to each other and a possible increased demand for ECB cash.

A Reuters poll showed banks are seen taking up some 155 billion euros at a one-week cash tender on Tuesday, compared with 187 billion euros expiring, and 123 billion euros at Wednesday's three-month tender, compared with 129.5 billion expiring.

JPMorgan's global market strategist Nikolaos Panigirtzoglou said he expects a "minor reduction" in banks' demand for one-week funds due to low Eonia rates, while the take up at the three-month cash should be similar to the amount expiring.

These levels would still be very elevated, he said.

"Peripheral banks are borrowing more at the ECB and the fear in the periphery is reducing the credit lines that some banks are willing to provide to interbank markets, especially the unsecured markets," Panigirtzoglou said. "This is putting more upward pressure on demand for cash from the ECB."

Barclays Capital strategist Giuseppe Maraffino said he expected demand to fall by 10 billion euros at the weekly tender and remain roughly the same for the three-month cash. "Should uncertainty on Greece increase in the next two days, I expect focus to switch to the three-month operation. The risks are on the upside for the three-month tender," Maraffino said.

CONSTANT STRESS

The low euro interest rates are hiding interbank stress, but banks' reluctance to lend to each other can be observed in US dollar funding markets. The one-year euro/dollar cross currency basis swap last traded at 35 basis points, a tad lower than a four-month high of 37 bps hit earlier this month.

This may indicate a similar amount of stress with that seen last week before the confidence vote eventually won by Greek Prime Minister George Papandreou, which may mean demand for ECB cash should stabilise around last week's levels as well.

"A lot of funding has already been cut during the last few weeks," said UniCredit strategist Luca Cazzulani. "There is this perception that US banks have stopped lending money to the European banks. This has already happened, so you would not expect a deterioration of the situation in the coming weeks."

"The risk is in that direction, but if I were to make a forecast, I would say that the bulk of increase (in demand for ECB cash) has already taken place in response to this decrease in lending from the US"

The Greek crisis is also hitting ECB rate hike expectations. Bets still remain in place for a 25 bps increase in July, a move the bank signalled after its June meeting, but afterwards the bank is seen pausing until the first quarter of next year.

That compares with bets placed after April's rate hike that the ECB would raise rates once a quarter.

"The next (hike) on the (EONIA) curve should be October, but it is now only 40 percent priced in, so the next one fully priced in is ... in February or March," said Elaine Lin, rate strategist at Morgan Stanley. "Given what's going on right now (in Greece) ... they have more space in October not to move."

Copyright Reuters, 2011