By Dhara Ranasinghe
LONDON (Reuters) - As the European Central Bank prepares to ramp up its quantitative easing programme, concern is growing that the flood of cheap cash is squeezing markets once seen as vital channels for signalling and enacting monetary policy.
Volumes in the euro overnight interbank index average (Eonia) market hit record lows this month, prompting traders to question whether this closely watched interest rate can remain a trusted indicator of ECB policy expectations for policymakers and investors alike.
QE has also cut volumes in the repo market, usually a vital source of funding for banks and companies. Industry body ICMA said last week the market had shrunk so much as a result of QE that it might struggle to recover when the euro zone economy rebounds.
For the ECB, these markets are a key transmission mechanism for its monetary policy.
The ECB traditionally tries to influence those rates, which are often components of borrowing costs for consumers and companies, but if low volumes lead to higher volatility, the ECB may lose its grip on them.
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"It is always a worry when lower market activity reduces the solidity of a market price," said Francesco Papadia, a non-resident fellow at the Bruegel Institute in Brussels and a former director general for market operations at the ECB.
"The experience of Japan during its first period of quantitative easing, when the short-term money market practically vanished, is generally regarded as an unfavourable experience," he said.
"Still this drawback has to be evaluated against the need, which the ECB is stressing, to ease policy to regain price stability, from too low a level."
Eonia volumes have been on a downward trend since the ECB unleashed its 1 trillion euro asset-purchase programme in March this year, pumping markets with cash but indirectly discouraging lending between banks. Stricter banking regulation has also squeezed trade.
Volumes hit a record low of 8 billion euros earlier this month, down from about 20 billion in August and more than 30 billion euros just after QE was launched.
IN THE PRICE
Overnight Eonia rates are considered key indicators of market rate expectations because they reflect actual lending rates between banks, as opposed to other money market instruments that are less liquid or derived from a survey of participant banks.
While they currently price in a 10 basis point cut in the ECB's deposit rate next month -- in line with other money market instruments -- there is a risk that a persistent decline in volumes means Eonia rates become too volatile to be a trusted indicator of ECB policy.
"It is getting a bit more tricky to derive market rate expectations," said ING senior rates strategist Martin van Vliet. "Many traders are wondering what happens next because ECB QE is very much ongoing and if anything they (policymakers) want to expand it, so what is going to happen to Eonia volume trajectories -- will they go to zero?"
The ECB currently buys 60 billion euros ($64 billion) worth of assets a month and that number is expected to rise in December as the central bank tries to stimulate inflation and economic growth in the 19-member euro zone.
ALTERNATIVES?
If Eonia volumes decline further, investors and policymakers may turn to other instruments to gauge market rate expectations such as Euribor rates, Bubills -- German government paper with maturities of up to 12 months -- or Eonia forward rates.
"Overall a smaller Eonia market is an operational problem, that the ECB can manage, not a sort of critical issue," said Papadia.
But two euro zone money market dealers told Reuters that a further drop in volumes could potentially lead to Eonia being ditched by the central bank as a key indicator of market rates.
Traders added that the ECB could also take action to boost volumes, for example by expanding the number of banks involved in fixing the Eonia rate.
The Eonia fixing is calculated daily as a weighted average of the rates on overnight lending transactions, which are contributed by 35 euro zone banks.
"This is something to monitor and anything the ECB says on this should be considered," said Chris Huddleston, head of money markets at Investec. "I don't know if there would be an alternative that would be as robust and reliable as Eonia."
(Additional reporting by Francesco Canepa; Editing by Nigel Stephenson and Catherine Evans)