Eurozone short-term interest rates inched lower on Friday and could fall further as talk of a Greek default gathers pace, increasing pressure on the European Central Bank to provide abundant liquidity and possibly slash rates. Traders of all asset classes are increasingly speculating that the ECB could cut rates in a bold 50 basis point move in October, reversing this year's two rate hikes, although the bank has only signalled a pause in its hiking cycle.
Euribor futures rallied by up to 10 bps on the 2011-2012 strip, implying lower future interest rates, while interbank stress indicators continued to edge higher after Greece's Finance Minister Evangelos Venizelos was quoted as saying an orderly default was being considered.
With eurozone politicians showing no signs they have a plan to resolve the crisis, markets are increasingly banking on more action from the ECB. That is fuelling expectations the ECB will cut rates back to a record low 1 percent before the end of the year and possibly introduce new liquidity facilities, ease collateral rules further, or step up their government bond purchases. Any of these would lead to lower money market rates.
"A number of the solutions with respect to the European sovereign debt crisis are quite hard economically, politically and perhaps legally to put into practice," said Ken Dickson, investment director for FX and money markets at Standard Life, which manages assets worth 157 billion pounds.
Dickson expects the ECB to cut rates by 25 basis points by the end of the year, but he is unsure whether the bank's outgoing president Jean-Claude Trichet will do it himself at the October meeting or will leave it to his successor Mario Draghi. The forward overnight EONIA curve is fully pricing in a 25 basis point reduction in October and some chances for a deeper reduction by the end of the year, analysts said.
Societe Generale's head of fixed income strategy Vincent Chaigneau interprets the Eonia curve as pricing in equal chances for each of the three October meeting scenarios - flat rates, a 25 bps cut or a 50 bps cut. The rate is currently quoted at 0.53 percent. Chaigneau, who said the November Eonia rate would trade closer to 0.40 percent if the ECB also reintroduced one-year unlimited euro liquidity tenders, recommended stops at 0.62 percent.
The three-month FX basis swap was minus 110 bps, 3 bps tighter from Thursday's widest level, while the 5-year hit an almost three-year low of -46.25 bps on Friday, 2 bps wider from the previous day. Commerzbank's rate strategist Benjamin Schroeder expects the dollar tenders to cap the three-month FX basis swap within a -105 to -110 bps range.