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Excess cash drop lifts money market rates, short-term yields eyed

* Eonia ticks up, tipped to rise further

* Excess liquidity drops to one-month lows

* Futures show short-term yields could rise

* Bund yields edge up on above-forecast flash PMI data

LONDON, July 24 (Reuters) - Euro zone money market rates edged higher on Thursday and were expected to rise further in coming days, potentially driving up short-term government bond yields, after a drop in excess cash in the bloc's banking system.

The euro overnight interbank lending rate moved back up to the top end of its recent trading range on Wednesday, analysts said, while forward rates imply it will almost double by the European Central Bank meeting in September.

"The market is pricing in this scenario we have been expecting all along - one with downside risks to liquidity and upside risks to rates for most of this summer," said Christoph Rieger, a strategist at Commerzbank.

The spare cash in the euro zone banking system dropped to 104 billion euros on Thursday, its lowest in over a month, after a bumper 21 billion euros of long-term loan repayments by banks on Wednesday.

"This will have an upwards pressure on Eonia. From currently around about 5 (basis points), I could see it move up to 8, maybe 9," said RBC's head of European rates strategy Peter Schaffrik.

A push higher in money market rates should also see short-dated bond yields rise more than those on longer-term bonds, strategists said.

Commerzbank's Rieger said German bond futures already show this trend with two-year Schatz futures close to their lowest in a month and 10-year Bund futures at one-month highs .

Strategists predict this trend will continue during the northern summer months, but that the liquidity squeeze is likely to ease in September when the European Central Bank offers its first round of targeted long-term loans to banks.

In cash bonds, German 10-year yields edged 2 bps higher on Thursday to 1.17 percent, as preliminary data showed the country's services sector growing at its fastest rate in three years.

The euro zone's private sector expanded at the fastest rate in three months in July. Market participants tend to see strong economic data as dulling the chances of the ECB taking further policy loosening steps that will buoy government bonds.

Spanish and Italian bonds were the best performers in the euro zone. Spain's 10-year bond yields dropped 2 bps, returning to record lows hit on Wednesday of 2.54 percent. Italian equivalents also dropped 2 bps to 2.72 percent, close to record lows.

Traders said Italy's decision to cancel scheduled bond auctions in mid-August had created more demand for peripheral bonds in the secondary market.

(Editing by Nigel Stephenson)