By Marc Jones and Kirsten Donovan
FRANKFURT/LONDON, Sept 24 (Reuters) - The European Central Bank's upcoming one-year cash tender will make policymakers think hard about when to withdraw their special crisis measures, despite promises that they won't move until a recovery is sure.
Lacklustre demand on Sept. 29 could strengthen the ECB's belief that money markets are on the mend, and automatically cement the first step of its much anticipated exit strategy.
But strong demand would mean levels of cash held by banks remain at exceptionally high levels until the middle of next year, unless the ECB takes steps to drain it from the market.
The ECB is showering the banking system with funds to force down market interest rates, part of a strategy to help the euro zone out of recession which also includes low official rates and purchases of covered bonds.
According to the latest Reuters poll, traders expect banks to take 125 billion euros at the second of the ECB's three special one-year tenders on Sept 29. However, uncertainty is high with forecasts ranging from 50 to 300 billion euros.
ECB President Jean Claude Trichet has made it clear that policymakers have no intention of withdrawing the unconventional support measures they put in place during the financial crisis before economic recovery is a given.
However, economists and traders think they will inevitably reassess matters after next Tuesday's one-year tender.
"Their hands are really tied for the remainder of the year," said Christoph Rieger, a rate strategist at Commerzbank.
"But depending on the demand seen now and at the next tender in December, they will either actively have to search for the exit or, if there is not so much demand, they can keep with the automatic exit that is built into their strategy."
Commercial banks are already loaded up on the near half-trillion euros they borrowed at the ECB's first offering of unlimited funds at one percent in June.
Those 12 month loans return automatically to the ECB only in June 2010, and rampant demand in next week's tender would put the ECB in uncharted money market waters.
Were banks to take more than 150 billion euros from the ECB, assuming the euro system needs around 600 billion to function, they would have all the money they need, plus extra, for at least the next nine months in long-term cash alone.
That would make it impossible for liquidity to return to anything like pre-crisis levels before June 2010, when the banks have to repay the 442 billion they borrowed in the first tender.
LAST CHANCE?
Some analysts say banks will stock up next week as it may be their last chance to get long-term ECB cash at 1 percent. Banks have cut back borrowing in shorter-term ECB operations recently, suggesting they are saving themselves, and their collateral.
ECB policymakers are keen to avoid repeating past mistakes made by Japan by removing support too soon, but large demand could spook them into trying to drain cash from the market.
"If there is strong demand for the one-year (tender) then that is more likely to provoke a reaction from the ECB. They will certainly have to debate it," said one London-based money market desk head who wished to remain anonymous.
Despite some very gentle tightening in recent weeks, money markets are pricing in only a gradual increase in rates until the third quarter of next year.
According to BNP Paribas, overnight rates at the start of next year are currently priced at 0.44 percent, suggesting markets are not positioned for any major reduction in liquidity.
"The Eonia curve is telling you that between now and August there is only a very gradual reduction of liquidity. That is probably wrong," the desk head said, warning that markets might be wrong to discount an ECB liquidity purge.
The excess cash bloating the system has seen overnight bank-to-bank lending rates plunge to around 0.35 percent, well below the ECB's main rate of 1.0.
Nomura economist Laurent Bilke also thinks the ECB will drain liquidity as it tries to regain its grip on rates, but not before February. Any sooner would see it override money markets, as it would be both selling and buying cash in the market.
"Removing some of the excess liquidity would certainly drive interest rates higher in the short end of the money market curve, bringing them above the main rate," said Bilke. If banks tense up again "the impact could be worth the equivalent of about 100 basis point tightening", he added.
LOW DEMAND?
In line with traders views in the Reuters poll, many analysts expect lower demand at next week's tender. The plunge in interbank rates has made borrowing in the market more appetising and hedging ECB borrowing more expensive.
Aurelio Maccario at UniCredit in Milan said ECB policymakers might consider charging more than one percent interest for the third refinancing tender at the end of the year.
"If they see good signals, i.e. much lower demand, they may start to contemplate the possibility to apply a spread at the December refi in order to signal the willingness to start unwinding part of the unconventional support," he said.
The ECB's money market group, a mix of ECB and commercial bank experts, discussed the option of adding a spread this month. It also talked about reducing the number of ECB liquidity operations, something else likely to be seen as a sign the ECB is moving towards the exit.
BNP Paribas calculates that were banks to take 100 to 200 billion euros at this and the December refi, there would probably be excess cash in the system until mid-next year.
But if banks take 50 billion or less at the tenders, and the ECB's covered bonds purchases are not included, the system could be short of its neutral level from the beginning of next year. (editing by David Stamp)