LONDON, Jan 26 (Reuters) - German two-year bond yields hit a record low on Tuesday as a fall in oil prices back below $30 a barrel prompted money markets to position almost completely for a European Central Bank deposit rate cut 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 increase inflation.
However, market-based inflation expectations on any time horizon 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 1.56 percent, a level last seen before the quantitative easing (QE) scheme was launched in March 2015.
The main catalyst for the falling expectations is the price of oil, which fell as low as $29.35 a barrel on worries about over supply by top producers and more signs of a Chinese economic slowdown.
Money markets are now pricing in a higher than 90 percent chance of a 10 basis point deposit rate cut to -0.40 percent, judging from the difference between spot overnight EONIA rates and forward EONIAs dated for future ECB meetings.
“There’s a lot they can do, but for me the easiest step for them to take is a further rate cut,” said Nordea’s chief fixed income analyst Jan von Gerich.
German two-year bond yields hit a record low of minus 0.457 percent, before edging slightly higher to minus 0.448 percent. Ten-year Bund yields were 0.37 percent, down 3 basis points in line with their euro zone peers.
Money markets price in around 18 basis points worth of rate cuts by the end of the year.
Across the Atlantic, U.S. Federal Reserves officials meet on Tuesday and Wednesday for the first time since raising interest rates in December in its first such move in nearly a decade.
While no further action is expected, investors will parse their statement to see how recent events in oil markets and in China have influenced the central bank’s outlook.
“Unless there is a strong turnaround in the data soon, the two rate hikes we have pencilled in for June and Q4, look in need of a serious trim, whilst the four hikes the Fed implies with its dot diagram look totally unrealistic,” said ING chief international economist Rob Carnell.
Five-year, five-year breakeven forwards in the United States trade around 1.90 percent at some of their lowest levels since at least 2013, having fallen 30 basis points this year alone.
Analysts expect the Fed to play it cool for now, having hiked rates so recently, but any sign that they may reconsider their outlook may have significant repercussions on Europe.
“That adds pressure on the ECB to do a bigger easing package ... because we may see a strengthening of the euro on the back of that,” said von Gerich, who does not expect any clear backtracking message from the Fed at this meeting. (Editing by Jeremy Gaunt.)