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Both China and the euro area are currently experiencing liquidity squeezes. China's is, perhaps, understandable, as banks, businesses and households prepare for the New Year holiday. The 7-day repo rate nearly doubled today to 8.47%.

The squeeze in Europe appears less understandable. The ECB's dovish forward guidance is clear and does not lack the doubts seen in the UK, or to a less extent, the US. However, in a usual occurrence overnight rates (EONIA) has moved above the refi rate (25 bp), when it should be trading close to the deposit rate (ZERO).

In part, what is happening is the decline in excess liquidity in the euro area. This Great Graphic, from Bloomberg, shows the trend over the past year. Excess liquidity is essentially the money that financial institutions deposit at one of two facilities at the ECB adjusted for the average reserve requirements. It has fallen from over 600 bln euros to almost 130 bln. This mostly reflects the European banks repaying the LTRO borrowings. Although the pay down announced for next week of just less than one billion euros, is the least since October, the continued repayment is expected to be feature through 2014.

It was the excess liquidity that kept the EONIA near the floor of the ECB's rate corridor. This corridor is defined by the zero deposit rate and the 75 bp lending rate. Typically, EONIA will not trade above the rate that banks could secure funding for at the main refi rate (25 bp), but it is capped by the lending rate. In addition to the level, the volatility is also disconcerting.

If disinflation pressures or weak money supply growth, or stubbornly high unemployment does not spur the ECB into action, some suspect it will ultimately be moved to stabilize money market rates, which Draghi seemed to underscore as a policy threshold at his recent press conference.

Some are talking about the possibility that the ECB responds by cutting the refi rate by 10 bp next month or in March. Cutting the refi rate does not seem to be a particularly effective salve for the money market tensions. This does not mean the ECB won't do it, just that it may have to do something else too.

Some observers may be tempted to consider the decline in excess liquidity to the Fed's tapering. This seems to be misguided. The Fed is still buying $75 bln of long-term assets this month and likely $65 bln next month. Its balance sheet is still expanding at a somewhat slower pace. Whether one wants to look at flows or stock (of holdings), the Federal Reserve is still easing. In Europe, bank's obligations to the central bank is being reduced. Financial conditions are tightening.

Source: Eurosystem's Excess Liquidity