LONDON: Financial markets expect the European Central Bank to cut its deposit rate by at least 10 basis points and expand its asset-buying programme this week, but they still do not expect it to hit its inflation target in the near future.
Euro zone government bond yields and short-term interest rates fell on Tuesday after weak Chinese trade data revived concern over growth. Wariness before Thursday's ECB meeting prevented a test of last week's lows, though.
Markets are pricing in a deposit rate cut to -0.4 percent and 10 billion to 30 billion euros of extra bond buying every month. Long-term inflation expectations suggest, however, that those measures may not be effective - consumer price growth is not forecast to hit the ECB's target of just under 2 percent .
Concern that negative interest rates could irreparably damage the financial sector has also led to some speculation the ECB will introduce tiered interest rates, as Japan has .
And after being disappointed in December, when policymakers delivered less monetary easing than they had suggested, investors doubt the ECB will be more aggressive.
"Having been burnt once already in December last year, expectations around this week's meeting are much more tempered," CMC Markets chief markets analyst, Michael Hewson, said.
The market's favourite inflation indicator, the five-year, five-year breakeven forward, is trading at 1.49 percent - more than 30 basis points below levels seen just before the December meeting.
Germany's benchmark 10-year Bund yield is trading at 0.17 percent, about 7 bps above last week's 10-month low of 0.102 percent - within sight of last April's record lows of 0.05 percent.
The two-year yield dipped 1.5 bps to -0.56 percent, near last week's record low of about -0.58 percent.
Commerzbank anticipates a 20 bps cut in the deposit rate and a 20 billion-euro rise in monthly asset purchases.
"They don't want to disappoint this time around," said Commerzbank strategist Rainer Guntermann. "What's different is that we have low inflation expectations ... and a more fundamental backing for the ECB to ease monetary policy further."
Market talk says the ECB may extend quantitative easing beyond March 2017 and buy other assets, such as corporate bonds, bank debt and even gold.
If the ECB does ramp up QE, it may have to consider relaxing some of its restrictions on bond purchases to prevent running out of assets to buy.
One option it may consider is scrapping its ban on buying bonds yielding less than its deposit rate. German bonds with maturities up to eight years carry negative yields and those with maturities out to January 2022 are trading below the -0.30 percent deposit rate.
"The ECB is close to exhausting its room to manoeuvre on interest rates and if more easing is required, QE will have to play a bigger role," Pimco said in a note on Tuesday. He expects the ECB to remove the yield floor for purchases and introduce tiered rates
Nordea chief fixed income analyst, Jan von Gerich, who expects a 10-bps cut and a 10 billion-euro rise in monthly purchases, said there was room for a "mildly positive" surprise.
December's disappointment was the exception to the rule for ECB President Mario Draghi, who effectively put the euro zone debt crisis to bed in 2012 by promising to do "whatever it takes" to preserve the euro.
"On some measure we will probably see a surprise that is hard to guess beforehand," von Gerich said. "The ECB has often done this. They can be quite creative in their thinking."
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