LONDON: Short-term euro zone interest rates fell to record lows on Thursday as markets interpreted a European Central Bank debate about two-tier deposit rates as signalling an aggressive cut was on the cards.
Overnight bank-to-bank Eonia lending rates dated for the ECB's Dec. 3 meeting fell below minus 0.28 percent, reflecting expectations the bank could cut the deposit rate to as low as minus 0.35 percent, from the current minus 0.20 percent.
But the Eonia pricing could also imply the market expects a two-tier deposit rate of minus 0.20 percent and minus 0.50 percent, some analysts say.
Euro zone central bank officials told Reuters the ECB was considering a split-level deposit rate based on the amount of cash banks deposit with the ECB.
Such a measure would reduce the impact of negative deposit rates on the banking system, particularly on banks in Germany and France, which keep more cash with the ECB.
The debate suggests ECB policymakers are looking for ways to cut deposit rates as much as possible while limiting the pain on banks, market players say.
Before the Reuters report, money markets were pricing in only a 12.6 basis point cut, and now they are expecting rates to fall by 15.3 bps, according to Rabobank estimates.
"The new approach would remove some of the obstacles against a more negative deposit rate," said Julius Baer's head of fixed income research Markus Allenspach.
ECB easing expectations pushed euro zone bond yields 1-2 bps lower, with German five-year yields hitting new record lows of -0.196 percent and two-year yields hovering just above lows of -0.418 percent.
German bonds with maturities of up to seven years carried negative yields and those with maturities out to September 2020 traded below the current -0.20 percent deposit rate, thus being ineligible for ECB bond purchases, according to the current rules of the trillion euro quantitative easing programme.
Bayerische Landesbank senior analyst Norbert Wuthe said a two-tier deposit rate "would theoretically extend the purchase universe to shorter maturities".
"The ECB could select the lower of the two deposit rates as the yield floor for its bond purchases or choose a weighted average of the two rates," Wuthe said.
Ten-year Bund yields were flat at 0.47 percent. Citi strategists expect them to find "equilibrium" around 0.20 percent, given the new monetary stimulus coming up.
Assuming banks would be charged one rate on half of their deposits and another rate on the other half, the cost for the banking system in a -0.2/-0.5 percent deposit rate scheme would be similar to the -0.35 percent currently priced in, said UniCredit rate strategist Elia Lattuga.
"But the impact on rates would be larger," he said, explaining that if the amount of excess cash charged at -0.5 percent was sizeable enough, that rate could become the new benchmark for money market rates.
Societe Generale strategists also expect money market rates to fall towards the lower deposit rate, but they expect the spread between Eonia rates and the lower bound to be wider than the current spread between them and the single deposit rate.
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