May 30, 2012 / 2:30 PM / 7 years ago

MONEY MARKETS-Speculation of ECB interest rate cuts returns

* Markets pricing small probability of ECB rate cut in June

* Such bets likely to accumulate in coming days

* As in May, markets could set themselves up for letdown

By Marius Zaharia

LONDON, May 30 (Reuters) - Bets that the ECB will cut interest rates next week are again appearing in money markets, as Spanish and Italian debt yields are approaching levels that made the central bank introduce unprecedented easing measures last year.

The threat that Greece could eventually leave the euro and worries over Spain’s banking sector have prompted investors to sell Spanish and Italian debt, bringing the two countries’ borrowing costs closer to levels deemed as unsustainable.

The sheer size of their debt markets and their deep-rooted connections with other financial systems in the euro zone are reasons for investors to speculate that a policy response is in the works.

The European Central Bank is, as usual, seen as the most likely institution to take measures to cool market nerves because it can act faster than politicians. It has done it before in the past by injecting around 1 trillion euros of cheap loans into financial system in December and February.

Euro zone economic data this month has also been poor, supporting bets that the ECB may soon resume monetary easing, possibly by cutting its key refinancing rate by 25 basis points from a record low of 1 percent.

“Data ... have been softer, and then you have the Greece issue continuing to be unresolved and the Spanish issue continuing to be unresolved,” said Elaine Lin, a rate strategist at Morgan Stanley, whose economists predict a rate cut.

She said the euro overnight Eonia rate forward market was only pricing an over 10 percent probability of a rate cut in June and the chances were higher by another 10-20 percentage points for the July meeting. However, she expected markets to factor in a higher probability in the next few days.

A key rate cut, if also accompanied by a cut in the 25 basis points deposit facility rate, could trigger a 5-10 bps fall in the near-term forward Eonia rates towards the 20 bps level seen now in September-October Eonia forward rates, Lin said.

The lowest point on the 2012 Eonia curve is December, at 16 basis points, which implies an 80 percent probability that the deposit rate would be slashed in half, according to BNP Paribas rate strategist Matteo Regesta.

A Reuters poll of economists showed the ECB was likely to resist pressure to cut interest rates in June, but also pointed to a growing probability that it will reduce them later this year.

Speculation about ECB monetary easing has also been fuelling a rally in Euribor futures , implying bets for lower fixings of benchmark euro zone interbank three-month Euribor rates later this year.

The December Euribor future has gained back most of its losses made since Greece’s inconclusive election on May 6, which sparked fears the country may be on its way out of the bloc. The fall earlier this month also coincided with unwinding bets that the ECB would have cut rates in May.

The contract was last 3.5 ticks higher on the day at 99.46. That was one tick lower than the pre-election close on May 4, but some 15 ticks higher from the lows hit in mid-May.

The move higher in Euribor futures, which has been faster than the move lower seen in the very low Eonia forward rates, has led to tighter Euribor/Eonia spreads, which are widely used as a gauge of money market stress.

That is counter to what is happening in banking credit default swap markets - where investors can insure against banking defaults. The Markit iTraxx index of European senior financials CDS remains close to its highest level this year at around 300 bps.

BNP Paribas’ Regesta warned that Euribor futures could fall again as they have done after the ECB’s May meeting and this would trigger a widening of the Euribor/Eonia spreads consistent with the levels of stress felt in money markets.

“You have a decoupling between those spreads and the banks CDS now, but those spreads remain exposed to significant paying interest in coming weeks ... unless there is another policy response from the ECB at its meeting next week,” Regesta said.

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