While the debate rages among policymakers on when to even start talking about strategies for withdrawing emergency support for the economy, money markets are increasingly convinced the European Central Bank will have to begin testing the waters by the end of the year.
The ECB has provided banks with unlimited liquidity since the credit crisis worsened last September, effectively handing over control of money supply in the hope that the trade-off would be a return to normal lending for the everyday economy.
But with signs growing that the worst of the downturn may be over, sooner or later the central bank has to regain control of the amount of money circulating in the economy.
Unless it caps money supply, when it comes to raising official interest rates banks would have so much money on their books that any rate hike would struggle to filter through to the real economy.
There is already a huge excess in the system. Banks deposited 170 billion euros at the ECB on Tuesday, market rates have dived to record lows <EURIBOR=> while traders say they have even had to pay peers to take euros off their hands at times.
The ECB's problem is when and how to start withdrawing that stimulus — a hugely sensitive issue for broader financial markets. It has two more tenders this year to start to experiment on how to up the cost of funds, and it could also simply say that there will be no more 1-year money.
"It is unlikely the ECB will do an additional 12-month tender next year," said Citi economist Juergen Michels.
"If they did it would clearly reduce their ability to exit from the current very low level of interest rates. Banks would have funding secured at an extremely low rate well beyond the end of next year which is when we expect the ECB to start hiking rates again."
STRESS TEST
There is still much reticence from governments and finance ministries about approaching the issue of exit strategies but ECB policymakers are discussing it. Austrian central bank chief Ewald Nowotny said last week draining liquidity would be the first job on the list once the economy recovers. [ID:nLL641610]
But whatever the ECB does do, it will be a fine balancing act to keep market stresses — like those seen since Lehman Brothers collapsed last year — from returning.
The 442 billion euros the ECB pumped into the banking system in June will have to be paid back by banks on July 1 2010, while two more injections in September and December will expire by around the end of the year.
"I think there will be pressure points," said Societe Generale economist James Nixon.
"Each time we come to a situation where one of these longer term operations expires, if the ECB hasn't made a commitment to roll them, you could start to see money market tensions begin to creep back in."
The ECB's official line for now is that December's tender for one-year funding is the last planned. That would mean banks have to start looking elsewhere for their longer-term funding.
Unless money markets are back to full health, it could prompt a rise in 6 to 12-month interbank rates, while banks in need of funding would have switch back to the ECB's shorter-term operations, steepening the back end of the money market curve.
Before then, another tender in September and the ECB's other ongoing market operations offer policymakers the chance to tighten the strings by imposing a spread — or additional cost — on the funds it issues.
"The ECB may apply a spread to its financing operations to discourage banks to get cheap funds only to retain excess liquidity deposited at the ECB," said Unicredit chief euro zone economist Aurelio Maccario.
"However, in doing so, they have to be very careful to send the right message about their stance on the refi rate, in order to avoid unneeded volatility in the market."
TROUBLE
If it sticks to form, the ECB will drip feed markets the key information. Trichet is expected to reveal the interest rate for the next one-year refi at the bank's September news conference, give a hint on the December refi in November, and say which support measures it will keep, and which it won't, by December.
Goldman Sachs say the ECB's most likely exit route will be to gradually phase out all the extra liquidity operations it has introduced, terming the tactic "tightening by stealth".
A more crucial test of nerve could come when the ECB ends banks unlimited access to funds, and when, or maybe if, it retightens the quality of collateral it accepts from banks.
With markets priced in for a long spell of ultra-low interest rates and excess liquidity, any surprise move by the ECB to drain cash would jolt markets as people adjust positions to suit the tighter monetary environment.
It could also drain cash on a weekly or longer-term basis.
"There are still a lot of questions that have to be answered before next year, but market conditions will dictate what the ECB does," said BNP Paribas economist Patrick Jacq.
"Maybe they could announce another one year tender if required. What is sure is that the ECB will not take any risk in terms of liquidity. Last year was a major trauma."
