Money markets interbank outlook hinges on risk appetite post ecb

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* All eyes on ECB 3-yr tender, consensus demand at 492 bln* Risk outlook post-ECB tender to drive interbank rates* High take-up relief could give way to structural concernBy William JamesLONDON, Feb 24 Interbank markets will remain in the thrall of broader investor risk appetite next week as the European Central Bank reveals demand for its three-year loans, with a high take-up likely to buoy sentiment and push lending rates lower. Financial markets will be holding their breath on Wednesday when the ECB unveils how much three-year cash banks have borrowed in the second, and possibly last, ultra-long lending operation. In a bid to alleviate bank funding pressures the ECB has loosened collateral rules and temporarily opened up unlimited access to long-term loans - a move that has also soothed spiking tensions in the sovereign bond market. In the past, interest in central bank liquidity operations has been limited to money market experts seeking to gauge the impact on short-term interest rates. The traditional dynamic was the greater the excess cash, the lower rates would fall. But in a system already swimming in more money than it needs, bank-to-bank lending rates are now more likely to rise or fall depending on whether the refinancing operation boosts support for the euro zone's ailing sovereign bond market.

"The concept behind the three-year LTRO is not so much to support the bank funding issue as it is to support the sovereign funding issue - sovereign funding is the dog, bank funding is really the tail," said Pavan Wadhwa, global fixed income strategist at JP Morgan. The latest Reuters poll points to a demand of 492 billion euros at the long-term refinancing operation (LTRO). The first operation in December allowed banks to shore up their medium-term financing and supported sovereign bonds by encouraging banks to borrow cheaply and invest in higher-yielding Spanish and Italian debt. This time around, any demand in excess of refinancing needs is likely to be viewed as potential investment in peripheral bonds - a boon to risk markets that could, in turn, squeeze already-low interbank rates even lower.

"A big positive surprise would raise the idea that there's a lot of opportunistic behaviour by the banks and that would clearly support the liquidity-driven sentiment in the market and you would expect spreads to tighten further," said Elwin de Groot, senior market economist at Rabobank in Utrecht, Netherlands. Conversely, a below-forecast take-up could spook rates higher."What drives these interbank markets is partly the excess liquidity in the system, and there is a lot of that already; and secondly, any stress coming out of sovereign markets," Wadhwa said."Given the fact that sovereign markets are likely to underperform in the event that the take-up is poor, you would expect some degree of spillover into funding markets, but it's not going to be a dramatic impact."

WHEN THE DUST SETTLES Looking beyond the assumption that above-consensus demand would push rates lower in the first instance, analysts saw some risk that the move would not be sustained."If there's a big number it could be an initial positive reaction by the market, but then they will turn to looking at the crisis from a more fundamental perspective and whether this is enough to turn it around," de Groot said."In our view, we need more measures by European leaders to do that, so it could well lead to more negative market sentiment in the days following - even if there's a big take-up."Demand well in excess of the consensus may also raise broader economic concerns: in the first instance that banks were in worse health than the bullish market had assumed, before more structural worries come to the fore."That (knee-jerk) may move into a concern that banks might not be focusing on core business quite as much," said Peter Chatwell, rate strategist at Credit Agricole in London."Ultimately, to improve the macroeconomic environment we need banks not just to be full of funding, but looking to take real economy business opportunities."