LONDON: Euro zone money market rates hit a record low on Thursday and two-year German bond yields touched their lowest levels since last week's European Central Bank meeting, as investors bet low inflation may lead to more easing in the year ahead.
Markets were disappointed with the scale of the ECB's easing a week ago, when it cut its deposit rate and extended quantitative easing by six months, and initially priced out any further near-term moves.
Executive board member Yves Mersch then said on Thursday that a great majority of ECB governors do not want to boost the quantitative easing programme further.
But with oil prices hovering near seven-year lows, putting further downward pressure on inflation, expectations for more ECB stimulus have slowly crept back into the market. Short-term interest rates suggest investors see a 1-in-2 chance of another rate cut.
Data showing French annual inflation of a meagre 0.1 percent in November was interpreted by some in the market as showing that the ECB may have little choice but to do more to lift prices.
Such bets were further supported by comments from Governing Council member Erkki Liikanen saying the ECB has further monetary policy tools at its disposal and stands ready to use them if necessary.
Liikanen struck a contrasting tone to Mersch, but in a world of falling oil prices and stubbornly low inflation, the market chose to focus only on the ones that pointed to the possibility of further monetary policy easing.
Disregarding the fading prospects for more QE, investors focused on what they think are increasing chances of further cuts in the deposit rate.
"The most interesting point is that we have huge dissension within the Governing Council. Liikanen this morning and (ECB chief Mario) Draghi a few days ago saying they are ready to do more," Natixis fixed income strategist Cyril Regnat said.
"The market knows that the effectiveness of any more liquidity injections fades over time and that the only way to have a real impact on the euro/dollar and interest rate curves is to cut the deposit rate," he said.
ONE MORE CUT
The yield on two-year German government bonds dipped to a one-week low of -0.34 percent, below the -0.30 percent deposit rate.
The deposit rate cut went live on Wednesday when the new reserve maintenance period started. This pushed the spot Eonia overnight bank-to-bank lending rate to a record low of -23.5 basis points compared with a range of 13-15 bps over the past three months.
Money markets are pricing in roughly a 50 percent chance of a 10 bps cut in the deposit rate in the coming year, judging by the difference between spot and forward Eonia rates.
"The ECB is going to need to extend (QE) again in six months time and probably knock that deposit rate a little bit lower," said Chris Scicluna, head of economic research at Daiwa Capital Markets. "It's difficult to see how they can get back to 2 percent inflation," he said, referring to the ECB's target.
Next week's U.S. Federal Reserve meeting could also have an impact on ECB rate expectations.
Analysts will scour the statement that follows an expected first Fed rate hike in a decade for clues on how fast monetary policy will tighten thereafter.
A fast pace of tightening would ease the pressure on the ECB to relax policy even further because it would keep the euro weak. Conversely, any sign of a prolonged wait-and-see period after the hike will strengthen the euro and potentially delay the euro zone's economic recovery.
"The Fed will do some work in the place of the ECB because it will have an impact on the dollar and therefore the euro," said Sergio Capaldi, fixed income strategist at Intesa SanPaolo.
Yields fell across the euro zone, with German Bund yields down 3.6 bps at 0.57 percent.
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