(Updates prices for close)
By Marius Zaharia
LONDON, Jan 26 (Reuters) - German two-year bond yields fell to a record low on Tuesday as cheap oil and weak inflation expectations pulled down money market rates, implying that investors expect the European Central Bank to cut its deposit rate in March.
After suggesting on Thursday the ECB may ease monetary policy further at its next meeting, President Mario Draghi repeated a promise on Monday to help consumer prices rise.
However, market-based inflation expectations remain below the ECB's target of just below 2 percent.
The five-year, five-year breakeven forward, which shows where markets expect 2026 inflation forecasts to be in 2021, trades around 1.54 percent, a level last seen before the ECB began quantitative easing in March 2015.
The main factor in reducing inflation expectations is the falling price of oil and more signs China's economy is slowing.
Money markets are now pricing in a 90 to 100 percent chance the ECB will cut the deposit rate 10 basis points to -0.40 percent, judging from the difference between spot overnight EONIA rates and forward EONIAs dated for future ECB meetings.
"We believe that another 10-bps cut in the deposit rate ... is likely, with other options, such as an increase in the monthly pace of bond purchases, an extension of bond purchases beyond March 2017, and the loosening of current restrictions on bond purchases all open for discussion," said Tanguy Le Saout, the head of fixed income at Pioneer Investments.
German two-year bond yields dropped to minus 0.457 percent, before edging slightly higher to minus 0.453 percent as oil prices came off the day's lows to creep above $30 a barrel.
Ten-year Bund yields were down 3 bps at 0.37 percent. Other euro zone equivalents were also lower on the day.
Money markets are pricing in around 18 basis points worth of rate cuts by the end of the year. Benefiting from that, Spain sold three- and nine-month T-bills with record low yields on Tuesday.
Across the Atlantic, U.S. Federal Reserve officials meet on Tuesday and Wednesday for the first time since raising interest rates in December, its first increase in nearly a decade.
No further action is expected, but investors will be looking to see how recent events in oil markets and in China have influenced the central bank's outlook.
"The Fed faces a difficult balancing act in acknowledging investors' concerns over global growth without validating those fears by implying that December's lift-off was a policy mistake," said BlueBay Asset Management's head of credit strategy David Riley.
Five-year, five-year breakeven forwards in the United States trade around 1.90 percent, some of the lowest levels since at least 2013, having fallen 30 basis points this year alone. (Editing by Larry King)