Money markets ecb cash injection to keep rates pinned

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* Banks grab another half trillion euros of ECB funds* Money market rates may struggle to go much lower* Focus to return to interest rate cuts?By Kirsten Donovan and William JamesLONDON, Feb 29 A sharp increase in excess cash in the banking system following a second three-year ECB funding operation on Wednesday is set to keep money market rates pinned down but may do little to free up lending to the real economy. Banks took 530 billion euros in three-year funding on Wednesday, adding more than 300 billion euros of new liquidity into the system and pushing the ECB's balance sheet to more than 3 trillion euros. Excess liquidity is set to rise to more than 800 billion euros, which will keep money market rates very low. But they are unlikely to fall much further - the Eonia overnight rate is already trading at just 0.36 percent, only around 10 basis points above the ECB's deposit rate, which is seen as a floor."The increase in the liquidity surplus, from an already all-time high level, is unlikely to have much more of an impact," Barclays Capital analysts said."(It) will at very least keep a lid on repo rates and all short-end rates, and will actually likely continue to push some of them lower, for example Libor, as sentiment should continue to be positive and investors will continue to try and grab yields."

Benchmark three-month euro Libor rates fixed a basis point lower at 0.896 percent. Commerzbank strategist Benjamin Schroeder said that with rhetoric from ECB officials pointing to Wednesday's three-year operation being the last, the focus should return to the possibility of interest rate cuts. Eonia forwards are not pricing in a cut in March, but a few basis points of cuts are priced in over the next few months."The ECB is never going to pre-commit, they'll likely wait for the effects of these tenders to unfold," Schroeder said."That's what we are seeing in these Eonia forwards: rate cut speculation setting in only two months out."

What is less clear is whether the excessive cash will reach the wider economy with banks showing scant signs last month of lending on funds borrowed at the ECB's first three-year operation in December."The (financing operations) do not address the underlying solvency issues and ultimately funding stresses can quickly return," said RBS strategist Simon Peck. STRESS GAUGES EASE

What the cash grab has undoubtedly done, however, is to reduce financing risks for banks - the operations have provided funds to help institutions repay maturing debt after finding bond markets closed late last year. That financing amounts to some 750 billion euros in 2012, according to Credit Agricole, meaning some of the short-term positive effects on rates may wane as the cash is used to meet redemptions. But with those financing risks out of the way, indicators of financial system stress are expected to fall further. The spread between three-month euro Libor - the benchmark cost of borrowing on interbank markets - and the anticipated central bank rate (OIS) has narrowed to around 53 bps from over 90 in December. Forward markets point to that spread falling to around 35 bps by September as interbank rates come down. Credit Agricole strategist Orlando Green said he expected riskier assets to rise further after Wednesday's operation - sources have told Reuters the ECB wants it to be the last, which would be consistent with a fall in Euribor rates - another euro interbank rate."The general pace of decline in the three-month Euribor rate has been in a 0.4-0.8 basis point range, and there is nothing to suggest this move cannot continue at this pace," he said."As a consequence, the tightening of the Euribor-Eonia basis should continue, as an indication of diminishing banking liquidity risk."The three-month Euribor rate has fallen by more than 40 bps since the ECB's first operation on Dec. 23, reaching a 16-month low of 0.983 percent.