Money markets spanish bill sale points to collateral gathering

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* Spanish T-bill demand points to large 3-yr tender* Extra liquidity set to compress spreads* S&P sees higher cost of bank funding here to stayBy Kirsten DonovanLONDON, Feb 21 Extremely strong demand at a sale of six-month Spanish treasury bills on Tuesday suggested banks may take a sizeable amount of three-year funds from the European Central Bank next week. Demand at Tuesday's auction for the bills, which can be used as collateral at the longer-term tender, was more than 10 times the amount on offer, up from 7 times a month ago ."The looming three-year tender is clearly the key motive why demand was so strong at this sale," said Michael Leister, rate strategist at DZ Bank. "Banks are trying to get collateral and everyone is still trying to get through the open door."Spanish debt sales this year have been strongly supported by domestic banks, as have Italian auctions to a lesser degree, enabling the former to complete around a third of its 2012 borrowing target already.

Shifts in demand at the ECB's one-week and one-month tenders last week also reinforced expectations of a large take-up. Banks cut their intake of one-month funds to 14 billion euros from 39 billion euros in the previous tender, but raised their demand for one-week loans to 143 billion euros from 109 billion. That figure rose again on Tuesday with banks taking 166.5 billion euros in seven-day funding to increase gross liquidity in the banking sector to more than 875 billion euros, according to Morgan Stanley."It's difficult to interpret with the three-year tender coming up," said DZ's Leister. "But it remains very interesting to see what the outcome of that will be and also what expectations will be as these have been very fluid."The latest Reuters poll, released on Monday, pointed to a take up of almost half a trillion euros of three-year money, around the same amount as in December.

Around 100 billion euros of that will be rolled out of existing shorter-dated operations, Morgan Stanley calculates. Much of the funding from the December tender was earmarked for repaying maturing debt but the picture is less clear this time with February's operation the last announced chance to bolster reserves with the cheap longer-term cash. Even with the likely jump in excess liquidity, analysts see a limit on how far the Eonia overnight rate can fall, given it is unlikely to drop below the ECB's 0.25 percent deposit facility rates. As a result the spread between three-month interbank borrowing rates and anticipated central bank rates (overnight indexed swaps) looked set to narrow.

Forward spreads indicate it will fall from a current 56 basis points to 46 bps in June and 40 bps by the end of the year , driven by a further fall in interbank rates."A larger-than-expected take-up should be positive for risk and further support the tightening trend of Euribor-EONIA basis," said Morgan Stanley strategist Elaine Lin."However, a lower-than-expected take-up may prompt the ECB to more aggressively ease monetary policy."Even with so much liquidity in the banking sector, credit rating agency Standard & Poor's said on Tuesday that funding remained tight. Reflecting recent comments by money market traders, the rating agency said the gap between large banking groups with market access and those with little or no ability to tap wholesale funding remained firmly in place."The links between sovereign and bank credit risk are numerous, and the transmission from one to the other in the debt market is rapid, in both directions," S&P said."The higher cost of wholesale funding seems a permanent fixture of the brave new world of banking in the euro zone."