By Anirban Nag and William James
LONDON, Feb 14 (Reuters) - Euro zone banks' next repayment of emergency loans to the European Central Bank later this month could take some of the shine off the euro, much to the relief of policymakers who fret about a strong currency.
Banks, which took these loans in late 2011 and early 2012 to overcome funding problems because the euro zone debt crisis had made it tough for them to access capital markets, are likely to repay a lower amount than they did in late January. That should see the ECB's balance sheet shrink at a slower pace and cause a drop in euro zone money market rates.
All of which could see a resurgent euro, which has risen this year to reflect higher euro zone money market rates than in the United States and Japan, give up some of its gains.
'Money market rates play a very important role for the euro,' said Adam Myers, European Head of FX Strategy at Credit Agricole. 'We expect euro zone money market rates to ease and that will play a role in dragging down the euro towards $1.28 against the dollar in coming weeks.'
During January the euro moved in almost lock-step with the two-year Eonia rate, which shows how traders expect overnight interest rates to change. The correlation between the two reached 0.8, its strongest since the ECB first flooded the market with long-term loans in December 2011.
The euro jumped to more than 14-month highs against the dollar and a near three-year peak against the yen early this month after European banks repaid 137 billion euros borrowed through the ECB's longer-term refinancing operations (LTRO) two years ahead of schedule.
The repayment in late January, apart from shrinking the ECB's balance sheet, also drove money market rates higher and reflected what ECB President Mario Draghi described as improved financial conditions. It was a far cry from mid-2012 when fears of a banking crisis and a euro zone break-up drove the euro lower.
But, the first early repayments of a second batch of ECB loans, due to be announced on Feb. 22, are unlikely to be as large.
'The payback of the second LTRO looks set to be smaller given that it was primarily the southern European banks that participated in the second LTRO and are less likely to pre-pay those euros back to the ECB,' said Chris Turner, head of FX strategy at ING.
Data on Thursday showed that while the 17-country euro zone slipped into a deeper recession in the fourth-quarter, economic output in southern European members contracted even more, leaving their banks vulnerable to steep asset write-downs.
Turner said a lower payback of emergency loans would keep excess liquidity in the banking sector at comfortable levels and check a rise in money market rates. The euro would have to find a different 'engine' to rise beyond $1.36-$1.37, he added.
MONEY CURVES TO FLATTEN
A Reuters poll of money market traders forecasts the ECB will announce the early repayment of 125 billion euros of the second tranche of three-year loans.
That would be enough to push back expectations of when the surplus of cash in the euro zone banking system will drain below 200 billion euros -- widely seen as the point at which the overnight borrowing rate starts to rise.
The surplus is currently at around 490 billion euros according to Reuters data, and according to estimates from the ECB President Draghi, will remain above 200 billion euros after the Feb. 22 repayment.
The result should be a flattening of the euro money market curve as traders unwind some of the steepening caused by the large first batch of repayments.
'I would expect some volatility for the Eonia rates before Feb. 22 but afterwards Eonia should correct again and there will be a bull flattening on the curve,' said Giuseppe Maraffino, strategist at Barclays Capital.
Barclays expect one-year Eonia rates to fall to 10 basis points from their current 16 bps once the second major batch of repayments is announced. The rate peaked at 25.8 bps on January 28.
If that fall materialises, the outlook begins to look cloudier for the euro, analysts said.
'With Eonia locked near current levels, we doubt the two-year Eonia swap moves much higher -- the two-year Eonia swap looks as though it has come far enough for the time being,' ING's Turner said.
(Editing and graphic by Nigel Stephenson) Keywords: MARKETS MONEY/EURO
Copyright Thomson Reuters 2013. All rights reserved.
The copying, republication or redistribution of Reuters News Content, including by framing or similar means, is expressly prohibited without the prior written consent of Thomson Reuters.