October 12, 2016 / 4:26 PM / 9 months ago

GRAPHIC-Money markets start to bet on tweaks to ECB QE

LONDON, Oct 12 (Reuters) - For all the speculation in the past week about a "tapering" of ECB asset purchases, trade in money markets suggests some investors are betting on the central bank pursuing its bond buying spree by removing its self-imposed floor.

Talk that the European Central Bank will lift the ban on buying bonds yielding less than its deposit rate appears to be gaining ground, prompting benchmark euro zone two-year bond yields to fall far below money market interest rates.

As this graphic tmsnrt.rs/2dL8rQQ shows, the gap between two-year German government bond yields, the euro zone benchmark, and equivalent Eonia rates is at its widest in around four years.

Eonia is a weighted average of overnight lending between the most active credit institutions in the euro zone's money market.

"Removal of the depo floor entails the ECB buying across the curve (2 to 31 years) instead of just buying bonds above the depo rate," said Uffe Kalmar Hansen, a senior analyst at Nordea.

"Buying across the curve will therefore also impact two-year bonds where yields would be expected to fall. I wouldn't expect much movement in Eonia as it is tied to the depo rate. This would therefore result in spread widening," he said.

Given that markets are not anticipating the ECB will cut interest rates much further, analysts have been puzzled at the recent fall in short-dated bond yields and say speculation about tweaks to the ECB asset purchases help explain the move.

ABN AMRO estimates that removing the depo floor will free up 600 billion euros of German bonds for purchase. It expects the ECB to take this step and announce an extension of the 1.7 trillion euro programme by six months in December.

"The market is starting to price in the floor removal more. This is why bonds are outperforming money market rates like Eonia," said Kim Liu, senior fixed income strategist at ABN AMRO.

Reporting by Dhara Ranasinghe; Graphic by Nigel Stephenson; Editing by Ruth Pitchford

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