(Reuters) - The relaxed view of money markets to the quicker-than-expected repayment of the ECB's LTRO crisis loans suggests many players expect the central bank to delve back into its unconventional policy toolbox before the end of the year.
In the last two weeks banks have returned just over 10 billion euros and the average weekly payback has risen over the past four weeks by almost a third to 9.2 billion.
If that pace is maintained, the 330 billion euros of excess liquidity held by euro zone banks could fall to 200 billion - the level at which market rates have historically started to rise - in just over three months.
Add to that the fact that banks are also borrowing less at the ECB's weekly and monthly offerings of one-week and three-month funding and that trajectory steepens even more.
"Should the movement (LTRO paybacks) continue near term, markets might start to price in risks of less abundant liquidity conditions going forward," said Annalisa Piazza, a strategist at Newedge.
This would see market rates rise and be a de-facto tightening of ECB monetary policy, the last thing it needs when the euro zone economy is deteriorating and other major central banks have the printing presses running hot.
But despite the trend in LTRO paybacks, markets are not yet suggesting interbank rates could rise.
Overnight interest rates are flat across all maturities while longer-term rate expectations have fallen to record lows in recent days.
There are two possible explanations for the apparent mismatch. The first is an expectation that LTRO paybacks will drop off in the coming weeks so that liquidity remains sufficient to keep rates at their current lows.
That is not a universally-held view, however.
While Italian and Spanish banks - which many believe took the lion's share of the second of the ECB's two LTROs in early 2012 - may need to keep the money, almost 290 billion euros remains to be repaid from the first one - more than enough to impact rates.
The second possible explanation rests on the assumption that the ECB will have to dig back into its policy cupboard to help the euro zone out of its economic difficulties.
Weak data this week has bolstered the view that a traditional interest rate cut could come as early as next week, but there are also clear signs investors are looking for more.
Euribor futures, which rise when rate cuts and other forms of policy loosening are priced in, are at record highs as far out as 2017, suggesting investors expect something from the ECB to neutralise the lower liquidity that would be in the system once the LTROs are repaid.
Analysts are mixed in their views of what the ECB will do. The bank has a list of options ranging from tweaking rates and offering more cheap liquidity all the way to the type of full-scale quantitative easing being used by the Federal Reserve, Bank of Japan and Bank of England.
"At the moment market expectations are clearly for further action from the ECB. Not only just a refi rate cut but also unconventional measures in terms of forward guidance (on rates) and measures to support corporates in particular in the euro area's periphery," said Norbert Aul a rate strategist at RBC Capital in London.
"In the current market environment this is counter-balancing the pressure (on rates) you could get from the liquidity drain."
Meanwhile, pricing also suggests that, like economists, markets remain sceptical about the chance of the ECB charging banks to deposit spare cash with it.
There are technical and psychological difficulties which limit the appeal of such a move. Trading systems may not be able to handle negative rates, while ECB policymakers have cited how a similar move in Denmark resulted in banks charging customers more for loans.
"The expectation is that they will take other measures in the near future, be that pure monetary policy or non-standard measures. Personally I think we will see both before the end of the year," said one London-based euro money market trader.
"I reckon they will come up with something not dissimilar from the Bank of England's funding for lending scheme to target specific sectors of the economy, the private sector and small and medium sized businesses," he added.
(Editing by Nigel Stephenson)
Copyright 2012 Thomson Reuters. All rights reserved.