LONDON: Financial markets have priced in only a marginal chance of a European Central Bank rate cut this week even with oil prices at just over half levels the ECB's 2016 staff forecasts are based on and long-term inflation expectations at 3-1/2 month lows.
Euro zone bond yields edged higher on Monday and short-term interest rates held steady in a sign of caution after ECB President Mario Draghi unusually failed to meet the market's expectations in December.
He delivered a 10 basis points cut in the deposit rate to -0.30 percent and extended the 60 billion euros a month asset purchase programme by six months until March 2017. ECB signals before the meeting had seemed to prepare the market for a package of deeper rate cuts, an increase in monthly purchases and other measures.
Draghi had built a reputation for surprising financial markets with the force of his actions ever since a 2012 pledge to do "whatever it takes to preserve the euro". Markets have been showered with unprecedented monetary stimulus since the global financial crisis erupted in 2008.
"I do not recall other policy meetings where Draghi surprised the market in such a negative way," said Rabobank senior market economist Elwin de Groot. "That signalled to me reluctance to do more."
Reuters exclusively reported last week that many ECB policymakers are sceptical that further policy action is needed in the near term, after conversations with five of them.
German 10-year Bund yields, the benchmark for euro zone borrowing costs, were up 1 basis point at 0.48 percent, having fallen around 25 bps from the highs hit after the December meeting. Yields have been pushed lower by oil's freefall and concerns over an economic slowdown in China.
WORSENING OUTLOOK
Oil prices hit their lowest since 2003 at $28.36 on Monday. The ECB's 2016 staff forecasts -- which see economic growth at 1.7 percent and inflation at 1.0 percent -- assume oil prices at $52.20 a barrel.
Sensitive to moves in oil, long-term inflation expectations as measured by the widely-followed five-year, five-year breakeven forward, hit their lowest levels since early October, below 1.60 percent.
The measure, which shows where markets see 2026 inflation forecasts in 2021, has fallen more than 20 bps since the December highs and is now less than 10 bps above troughs hit in January, a week before the ECB announced quantitative easing.
One-year inflation swaps at just below zero show the market expects inflation to fall from current levels of 0.2 percent rather than head towards the ECB's target of just below 2.0 percent. Thirty-year inflation swaps were just above 1.6 percent.
A weaker euro would help lift inflation and boost exports, but at $1.09 it is almost 4 percent stronger than on the day before the December meeting.
Judging from the difference between spot overnight interbank lending rates and forward rates dated according to the ECB meeting calendar, money markets are pricing in a less than 10 percent chance of a further 10 basis point rate cut in January.
The probability is increasing to 50 percent in March and 100 percent by mid-year.
Barclays rate strategists said in a note they did not expect policy action this week but that the worsening inflation outlook had raised the pressure on the ECB to ease later this year.
"We think the Governing Council members will want to see the impact of the measures just decided in December before announcing another package. ... Our baseline is for action in June, unless a meaningful shock pushes it to act before."
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