Money markets euro rates march lower, room for more declines

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* Euribor rates continue fall* No barrier to falling below 1 percentBy Kirsten DonovanLONDON, Jan 27 Euro zone interbank lending rates continued to fall on Friday with plenty of room to slide further given the ample excess liquidity in the banking system, even before the ECB offers banks more three-year funding next month. Benchmark three-month Euribor rates dropped to their lowest since March 2011 at 1.138 percent, down from 1.142 percent in the previous session. The rate has fallen by more than 30 basis points since the European Central Bank announced in December that it would offer banks three-month funding with a take-up of almost half a trillion euros of the cash and another such tender at the end of February. With the three-month Euribor rate falling by just over a basis point a day on average since banks got the cash, the forward rate implied by the March Euribor future of 0.95 percent still holds significant downside potential should the rate of decline continue, Commerzbank strategist Christoph Rieger said.

"Granted the downside dynamic should subside at lower levels and some are pointing to the 1 percent refinancing rate level as providing support," Rieger said. However that argument did not stand up in 2009/2010 when the ECB first flooded the market with 12-month funding, pushing the three-month Euribor rate as low as 0.63 percent."We would not attempt to catch the falling (Euribor) knife yet," Rieger added. Excess liquidity in the banking system has averaged 449 billion euros this year, according to BNP Paribas, versus 102 billion euros in 2011 and 147 billion euros in 2010.

And that is before another three-month tender at the end of February at which a Reuters poll forecasts a demand of 263 billion euros, although many analysts expect a higher figure. Italian banks raised their borrowing from the ECB by 57 billion euros in December to 210 billion euros, while Spanish banks' borrowing rose 26 billion euros to 132 billion euros. German banks however more than doubled their borrowing to 55 billion euros, something Commerzbank says underscores the fact that taking liquidity from the ECB has lost its stigma and the only restriction to taking cash at the next three-year operation is availability of eligible collateral.

The ECB's tactic of providing liquidity has eased tensions in the banking sector, at least for the time being and markets are not looking for the central bank to cut its main refinancing rate any time soon. Some analysts do look for a cut in the bank's overnight deposit rate however, which would make it less attractive to park funds there overnight rather than lend them out. The amount of cash left at the ECB overnight over and above the average reserve requirement touched its highest since May 2010 earlier this maintenance period at nearly 140 billion euros, according to Reuters data. With the overnight Eonia rate settling a few basis points above the deposit rate, any cut in the deposit rate would pull Eonia rates lower and feed through to Euribor rates with the spread between the two narrowing as banking tensions ease."Euribor should continue to edge lower for two reasons," said Laurence Mutkin, strategist at Morgan Stanley."The market is underpricing the probability of a cut in the deposit rate, which would lead to a fall in Eonia and the excess liquidity should mean that banks have lower demand for unsecured cash."