LONDON: Euro zone money market rates fell to new lows on Tuesday and German Bund yields dropped below 1 percent as the region's weak recovery kept up pressure on the European Central Bank to maintain its ultra-loose monetary policy.
With a fresh round of tit-for-tat sanctions between Russia and the West in discussion as the Ukraine conflict rumbles on, investors are becoming increasingly certain that economic stagnation combined with low inflation will herald a prolonged period of low rates.
The ECB has already taken measures to keep borrowing costs low and ensure the euro zone banking system has ample spare cash, with new four-year loans (TLTROs) set to become available to banks from September. But strategists say current market prices are starting to price in further policy easing ahead.
"Low rates are simply an expectation of continued ample liquidity from the ECB, certainly through the TLTROs but maybe down the line through additional initiatives," said Lars Peter Lilleore, the chief strategist at Nordea.
Money market traders now see an even 50 percent chance of an asset-purchase programme, known as quantitative easing, in the coming year, a Reuters poll found on Monday.
Excess liquidity currently stands at 134 billion euros which helped push the euro overnight lending rate to a record low of 0.006 percent at Monday's fix.
The ECB decided in June to charge banks to keep their money in overnight deposits, hoping that this would stimulate lending into the real economy. It also injected liquidity into money markets by abandoning a tender to sterilise crisis loans.
Strategists say these policies are helping to keep spot Eonia near zero, and could even result in an unprecedented drop into negative territory.
"I wouldn't exclude the overnight rate dropping below zero, but I find it difficult to see banks charging negative rates on unsecured lending," said Benjamin Schroeder, a strategist at Commerzbank.
A higher-than-expected uptake at the ECB's weekly refinancing tender on Tuesday will partly offset LTRO repayments, keeping excess liquidity near current levels.
Forward money market rates are also at lows, pinned by September's upcoming cash injection. Looking further out the forward curve, Nordea's Lilleore said rates for 2015 suggest there will have to be negative daily fixings.
UKRAINE STRAIN
Longer-term rates are also near historic lows.
Yields on German 10-year bonds - the euro zone benchmark - fell back below 1 percent on Tuesday. They fell to a record low of 0.952 percent last week.
Germany plans to sell 5 billion euros of a new 2-year Schatz with a zero percent coupon on Wednesday.
Along with the Russian sanctions that have dimmed the outlook for the stagnating euro zone economy, a deflationary spiral is also a source of worry for the ECB.
German 10-year breakevens - the difference between yields on inflation-linked and nominal bonds - have dropped 25 bps in recent weeks, and at 1.2 percent are well below the ECB's target inflation rate of just below 2 percent.
"What has really driven the market here is poor macroeconomic data, probably compounded by the sanctions and the implication that this might have on economic activity," said RBC's head of European rates strategy, Peter Schaffrik.
Elsewhere on Tuesday, Portugal's 10-year yields dropped 9 bps to 3.42 percent. Ratings agency Fitch said partial approval by the country's constitutional court of expenditure measures reduced a key near-term risk and kept the country on track to hit fiscal targets.
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