Bloomberg/London

Debt and money markets are readying for a cut to the European Central Bank’s deposit rate, regardless of what its policy makers say in public.
Traders are pricing in a possible reduction to the rate for holding overnight deposits, said UBS Group and Barclays. ECB officials have declared it’s too early to expand stimulus and President Mario Draghi said more than a year ago that rates have reached their nadir. Economists predict changes to its bond-buying program, or quantitative easing, would come before any adjustment to more conventional monetary tools.
With inflation in the euro region once again negative, speculation has swelled that the ECB will tinker with policy, perhaps with the euro in mind. The currency’s recent appreciation has added to downside risks for growth and inflation outlooks, ECB Executive Board member Yves Mersch said. The central bank won’t hesitate to act if the inflation outlook weakens over the medium term, Mersch said October 13. The ECB meets next week to decide on monetary policy.
“The main objective for cutting the deposit rate would be to weaken the euro,” said Nishay Patel, a London-based fixed- income strategist at UBS. “It would not be a substitute for an increase in the QE program, which is able to provide stimulus to the economy.”
The deposit rate was set at minus 0.2% in September 2014, after first being cut below zero in June that year. Draghi said at the time rates had reached its “lower bound.”
Yields on Germany’s two-year notes were at minus 0.27% on Friday, meaning buyers would get back less than they paid if they held the securities until they came due. The market is pricing in at least a 50% chance of a cut of 10 basis points, or 0.1 percentage point, to the deposit rate, according to UBS strategists.
Two-year yields would move down to the new deposit rate if it’s cut, UBS’s Patel said. Five-year yields would move in step, keeping the spread between the two at about 23 basis points, while the 10-year yield would move less, he said. Any such action from the ECB should be supportive for short-dated core bonds amid the rise in excess liquidity, and so Patel recommends buying five-year French securities.
Last week, Draghi said the current quantitative-easing program has “surpassed our initial expectations.” He also said it will take longer to reach the central bank’s inflation goal, due to the drop in oil prices, and that the ECB is ready to expand its asset-purchase program if needed.
Money markets indicate traders are betting any additional stimulus will include a cut to the deposit rate: The euro overnight index average, or Eonia, rates has dropped.
“Eonia rates have rallied on mounting expectations of a depo rate cut,” Giuseppe Maraffino, a fixed-income strategist at Barclays in London, wrote in a note to clients.
A cut of 10 basis points wouldn’t hurt the functioning of the market, as it’s already operating at levels below the depo facility, he said. German general collateral rates in the repurchase agreement market - where bonds are used as collateral for short-term loans - have been below minus 0.2% since April, excluding month-end spikes.
On a trade-weighted basis, the euro has gained more than 3% since the ECB began buying bonds under QE on March 9. Should the common currency appreciate to a level that the ECB feels would harm the economic recovery, market participants would increase the probability of a deposit rate cut, UBS’s Patel said.
Draghi’s comments have stoked speculation a deposit-rate cut may happen. During the ECB president’s most recent press conference, when asked if interest rates had reached their effective lower bound, Draghi simply responded that the matter had not been discussed among the Governing Council.
This reluctance to restate the lower bond “could be viewed as a softening of position,” BNP Paribas analyst Ken Wattret said in a report. While adding that a rate cut is unlikely to be an initial response, they said it’s an option because of the appreciation of the trade-weighted euro, a limited amount of stimulus alternatives and officials’ acknowledgment that the adverse effects of negative rates haven’t been so bad.