Money markets ecb deposit rate cut may do more harm than good

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* Money markets increasingly pricing in ECB depo rate cut* Such a move may have adversely impact repo markets* May also increase volatility in sovereign bond marketsBy Marius ZahariaLONDON, June 25 Money markets are increasingly pricing in a near-term cut in the European Central Bank's deposit facility rate, but some players warn that such a move may do more harm than good by lowering banks' incentives to lend. With the euro zone economy faring worse than expected, the three-year-old sovereign debt crisis intensifying day by day and waning hopes that politicians can get a definitive grip on events, markets are increasingly banking on support from the ECB. Analysts say forward euro overnight Eonia rates are pricing in an over 50 percent chance that the ECB will cut its deposit facility rate from 25 basis points to zero later this year along with its 1 percent refinancing rate. But while this would be intended to give a further push to banks to lend to each other and then to businesses to help the real economy grow, it may actually have the opposite effect. Analysts say the few banks that are willing to lend in unsecured lending markets may stop doing so as their return on such transactions may fall below the cost.

More importantly, it could create distortions in the most active sector of the money markets, repo transactions, in which investors raise cash backed by collateral, usually government debt. The rate to borrow cash using top-rated general collateral (GC), such as a basket of German or French government debt, has recemtly traded 20 basis points below Eonia, the overnight rate for unsecured lending, because of the quality of the bonds on offer. Eonia, in turn, has settled 10 bps above the deposit facility rate on average in recent months - on Friday it fixed at 0.325 percent. Once the deposit rate is cut to zero, Eonia is expected to fix at around 0.1 percent.

"That would mean that the GC rate will be negative, limiting the ability to get money using the bonds. It can create a distortion in the repo market," said Alessandro Giansanti, rate strategist at ING. BOND MARKET IMPACT Any repo market distortion could also lower volumes in sovereign bond markets, as investors who buy government debt to raise cash will no longer have a reason to purchase them.

"This could add to the negative momentum observed in sovereign bond markets, which is reinforced by increased volatility and already impaired liquidity," Commerzbank rate strategist Benjamin Schroeder said in a note."Within the context of the broader sovereign crisis, it would be worrying if the ECB risked endangering the still very fragile bond markets in return for questionable positive effects for interbank lending."Not all analysts are worried that a cut in the deposit rate will have side effects on repo markets. Max Leung, a rates strategist at Bank of America Merrill Lynch Global Research, said repo rates on a few German bonds - posted as collateral individually rather than as part of a basket - have already turned negative and volumes have not dropped."Negative rates is never a good thing because you penalise people for lending, but there are securities which are already trading at negative levels because of flight-to-quality flows," Leung said."As far as banks are concerned it still represents business. For the repo desks, they can still charge relatively wide bid/offers so we don't think volumes will necessarily fall because of that."