Money markets see new cheap loans from european central bank in

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* Despite mixed signals, market expects more cheap ECB loans* Falling inflation, strong euro could force ECB to act* Dwindling liquidity seen pushing near-term rates upBy Emelia Sithole-MatariseLONDON, Oct 24 Euro zone money market investors are betting the European Central Bank will offer banks new long-term loans in 2014 to curb a surging euro and a potential rise in short-term rates that could derail a nascent economic recovery. Business survey data released on Thursday showing activity in the region's services sector unexpectedly slowed in October highlighted the fragility of the recovery in the euro bloc, fostering expectations the ECB will loosen policy further. ECB President Mario Draghi has signalled the bank will ease if needed but recent comments by some of his colleagues have cast doubt on whether this will involve fresh stimulus like the 1 trillion euros in low-cost three-year loans (LTROs) it offered banks in 2010 and 2011. Money markets are pricing in the possibility of a further rate cut or another LTRO with participants leaning more towards the latter as it has proven more effective in bringing down lending rates more broadly than a rate cut. A rate cut would also would not help interbank lending and so still leave weaker banks out in the cold and reliant on ECB largesse. Overnight bank lending rates, as measured by one-month Eonia forward contracts, remain well below the ECB's 0.5 percent refinancing rate until late 2015. The rates would move above the ECB's main rate if the market starts pricing in tighter monetary and liquidity conditions.

A further easing in ECB policy would drive money market rates lower, making the euro less attractive for investors. The single currency is at its strongest against the dollar in two years and threatening to choke export growth."The market is gradually positioning for the potential for the ECB to take another policy measure via a new LTRO during the course of next year," said Patrick Jacq, a strategist at BNP Paribas."This has probably been reinforced by the evolution of the euro/dollar which has strengthened very significantly and could cause some concern as far as the economic recovery is concerned."Draghi said earlier this month the ECB was "attentive" to developments in the euro exchange rate even though it is not among the bank's formal targets.

The euro rose above $1.3800 for the first time since November 2011 on Thursday as the dollar remained under pressure due to expectations the Federal Reserve will delay tapering stimulus until next year. It has risen 4.7 percent against the dollar and 5.3 percent versus sterling so far this year. Companies in the region are already feeling the pinch as the euro's trade-weighted index - reflecting its strength against a raft of other currencies - hit its highest in nearly two years. Anglo-Dutch company Unilever Plc reported slower sales growth after demand for its consumer goods was hit by the devaluation of a handful of emerging market currencies. German business software company Software AG warned with its results on Thursday that its profits could be hit if the euro stayed strong while Italian cable maker Prysmian said the strong euro was not helping.

APPROPRIATE TOOL A sharp fall in inflation could also give the ECB reason to act next year, analysts said. At 1.1 percent in September, inflation has fallen way below the ECB's close-to-2-percent target."Although the ECB doesn't target the exchange rate, this low level of inflation and further strengthening (of the currency) could be an argument for a rate cut," said Anatoli Annenkov, a senior European economist and ECB watcher at Societe Generale."But we still think that an LTRO is the more appropriate tool because on the one hand it could support a weaker currency and lower inflation while providing a liquidity backstop for next year."Money market rates may come under further upward pressure, and the ECB under pressure to act, as excess cash in the euro system is squeezed as banks repay earlier ECB loans. Rates usually start to rise once excess liquidity - the amount of money in the banking system above what it needs to function - drops beneath 200 billion euros. It stands at 187 billion euros, its lowest since late 2011, just before the ECB flooded markets with 1 trillion euros via LTROs."It's just a matter of time in the next few months ... we'll start to have more upside pressure on Eonia. That's something that the ECB doesn't want to see and could be a driver to push the ECB to deliver another round of LTROs," said ING strategist Alessandro Giansanti.