* ECB exit steps guarantee liquidity, control over costs
* May be tougher to keep short rates low
* Scope for Eonia to rise after June
By Kirsten Donovan
LONDON, March 12 (Reuters) - Exit steps announced by the
European Central Bank last week mean financial institutions will
have all the liquidity they need through the third quarter while
giving back to the central bank control over the cost of funds.
What may prove harder for the ECB to engineer is keeping
ultra short-term rates at their current lows, something analysts
see as necessary to avoid snuffing out the nascent economic
recovery with fiscal problems rumbling in countries such as
Greece and Portugal.
The ECB has plied banks with cheap funds since interbank
lending markets dried up after the collapse of Lehman Brothers
in late 2008 in an attempt to kick-start lending to the wider
economy and stave-off economic recession.
In its latest move to normalise monetary conditions and wean
banks off the unlimited amounts of cheap liquidity, the ECB will
in the second quarter shift to offering three-month funds at a
variable rate, as it did before the financial crisis bit.
However, it also pledged to continue to provide unlimited
shorter-dated money at a fixed rate until at least October,
meaning institutions that are still locked out of interbank
markets will have no problem accessing funding.
In a sign that markets are far from normal, the Eonia
overnight rate, now 0.32 percent, is set to stay closer to the
0.25 percent deposit rate than to the 1 percent refi rate, at
least until the end of June when 442 billion euros of 1-year
money has to be repaid to the ECB.
Eonia has historically fixed close to the refi rate.
After June there is scope for it to rise, with a knock-on
effect along the curve, pushing up the cost of borrowing.
"The risk is that as the term of full-allocation repos
shortens to just 1-month, banks will cease to borrow more than
they need to from the ECB," said Morgan Stanley interest rate
strategist Laurence Mutkin.
"As a result, deposit facility use will decline and Eonia
wil rise again towards the refi rate."
Forward rates anticipate Eonia will remain below 1 percent
until March next year, while the market is not fully pricing in
an ECB rate hike until July 2011.
Although the ECB has pledged to keep providing unlimited
liquidity, it will by July have wrested back control of the cost
of providing all of it bar 75 billion euros, and of all
outstanding funds by September, Mutkin said.
Outstanding operations will all either be linked to the
weekly rate, which the ECB can change, or be at a variable rate
which it can guide as was traditional before the credit crunch.
That contrasts with more than 500 billion euros of fixed-
rate funds that the central bank has no control of currently.
CAN THE ECB KEEP RATES LOW?
Analysts said the ECB's moves should not be interpreted as a
tightening signal, with bank President Jean-Claude Trichet
reiterating interest rates remain appropriate and signalling an
expectation Eonia rates would stay low.
Indeed, with fiscal strains in the euro zone, particularly
in Greece and with concerns mounting over Portugal and Spain,
there is an argument for monetary policy to stay accommodative.
But the ECB, even with the best of intentions, may not be
able to prevent short-term rates rising.
About 70 banks are taking around 80 billion euros at the
ECB's 1-week operations, despite traders quoting 1-week
unsecured interbank lending rates at about 0.3 percent.
Commerzbank rate strategist Christoph Rieger said demand at
above market rates may rise in coming months as expiring repo
operations may not be renewed if banks tighten credit lines.
Whether that will offset the outflow of liquidity when the
442 billion euros matures in June remains to be seen.
Banks need to roll 185 billion euros of the expiring money to
other ECB operations for neutral liquidity conditions to
prevail, the bank calculates, and more than 225 billion euros
for excess liquidity to keep Eonia below forward rates.
"The fundamental case for the ECB to keep rates low for
longer is as compelling as ever," Rieger said.
"Yet it would be treacherous to ignore liquidity issues,
which could lead to a different outcome than what is needed."
Funding that is not rolled into other ECB operations, may be
sought in the interbank or repo markets -- so long as these do
not deteriorate more broadly. That, Rieger said, could
potentially also push up government bond repo rates and
unsecured interbank funding rates.
