Money markets banks prepare for hefty take up of 3 year ecb cash

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* Expectations rise for a large 3-year ECB loans take-up* Short-term euro zone rates seen falling further* Euro/USD FX basis could narrow further, M. Stanley saysBy Marius ZahariaLONDON, Jan 25 Shifts in demand at European Central Bank cash tenders this week are pointing towards a large take-up of three-year loans by euro zone banks in February, strengthening the case for lower short-term interest rates in the near term. Investors who are nervous about the risk of a chaotic Greek debt default after another setback in talks on a debt swap deal, are drawing some comfort from the auctions' results, seeing signs that the euro banking system is building up a safety cushion. Banks reduced their intake of three-month ECB funding to 20 billion euros on Wednesday, compared to 45 billion euros they borrowed in October and 35 billion euros in a Reuters poll. On Tuesday, they took 130 billion euros in one-week cash, 10 billion more than expected."This is a shift of the collateral out of the three-month tender and into the one-week tender to have it ready for the three-year," Commerzbank's interest rate strategist Benjamin Schroeder said. A Reuters poll in mid-January showed the ECB is expected to hand out 263 billion euros at its second three-year cash tender in February, but Schroeder said expectations may have risen after Wednesday's drop in demand for three-month loans.

This compares to 489 billion euros taken at the first tender, but JPMorgan strategists estimate a 300 billion euros take-up would be "equally as powerful". They assume that 100 billion euros will be rolled over from existing liquidity operations, 100 billion euros would be used for prefunding maturing bank debt, leaving the other 100 billion euros for carry trades. This is what JPMorgan estimates was the level banks used to buy government bonds after the December three-year tender, halving rates on up to three-year paper in Spain and Italy and driving them lower elsewhere in the euro zone.

Interbank lending rates will also fall further after a take-up of around 300 billion euros as a result of an ever-increasing liquidity surplus in the euro system, analysts say. However, doubts remain that money market functioning would come back to normal. A large chunk of the collateral that could be used in the secured lending markets is going to be stuck with the ECB, while confidence to lend in unsecured markets is unlikely to pick up significantly as long as the sovereign crisis remains unsolved.

DOLLAR FUNDING The better euro liquidity conditions have filtered through dollar funding markets as well. The three-month London interbank Offered Rates (Libor) for dollars fell on Wednesday to 0.55660 percent versus 0.55910 percent in the previous day, having gradually dropped from around 30-month highs at the start of the year. Also, a gauge of dollar funding strains, the three-month euro/dollar cross currency basis swap which usually tightens when dollars are easier to find for euro zone lenders, narrowed below 80 basis points for the first time since August 2011 on Wednesday. Morgan Stanley's head of FX strategy Ian Stannard, who predicted in late December that the basis swap would narrow to 80 bps from three-year wides of 167 bps, said it could tighten further to 60 bps."The amount of liquidity which is now being made available is a big factor in helping to release the tensions in money markets so it is likely to see a gradual narrowing of the basis," Stannard said. He added that the deadlock in talks for the Greek debt swap deal which some traders say has prevented the basis swap from breaking the 80 bps level over the past few sessions will have a limited impact."As long as liquidity conditions remain more favourable which is the case now ... then the impact from the day to day neswsflow coming from Greece will be quite limited," Stannard said.