Money markets may struggle to make headway this week even if the European Central Bank indicates it is unlikely to raise interest rates again, given that prices already reflect expectations of an easing of policy. ECB President Jean-Claude Trichet last week bolstered expectations the central bank will keep interest rates on hold well into next year after hiking twice in recent months when he said the risks to price stability were under review.
The ECB holds its policy meeting on Thursday and markets will see a signal of a halt to tightening as a first step towards easing which some are already betting may come by the middle of next year. "We think the market will see the ECB signalling a pause as a preliminary step before a rate cut but going forward, which should be supportive for money market rates," said Giuseppe Maraffino, rate strategist at Barclays Capital.
"The market has already rallied a lot and pricing is quite aggressive... a change in wording would reinforce expectations going forward that monetary policy will be easier but we don't expect a massive rally as that has already happened." Only a few months ago the majority of economists and investors expected a steady run of ECB hikes, but the recent souring of the economy and intensification of the eurozone debt crisis has changed minds.
The June 2012 Euribor interest futures contract implies a Euribor rate of around 1 percent, down around 20 basis points since Friday, before dismal US jobs data was released, and compared with a current rate of 1.54 percent. But perhaps the biggest danger is that the ECB does not soften its language, in which case the market may reflect disappointment, with ING rate strategist Alessandro Giansanti seeing implied rates from the December Euribor contract rising to 1.30 percent from around 1.15 percent currently.
"The market will not drop expectations of a rate reduction as it will still think that if the situation worsens there will be some action from the ECB in future," he said. "But on Thursday language not so much in favour of a rate reduction will be seen on the hawkish side." Benchmark three-month euro Libor rates were half a basis point lower at 1.47813 percent, also pulled down by the large amount of excess liquidity in the banking system after the ECB extended its provision of cash last month.
The excess is a reflection of how reliant some banks - which hold large amounts of sovereign debt - are again becoming on the ECB handouts as the eurozone debt crisis intensifies. There is uncertainty over the implementation of a second Greek aid package while yields on Italian and Spanish bonds are only being held at sustainable levels by ECB buying in the secondary market.
The Bank of Portugal said on Monday that the country's banks' borrowing from ECB rose 4 percent in August, compared with July, as banks in country's bailed out by the eurozone remained unable to access money markets. Deutsche Bank believes that stresses in the banking sector are one factor which could see interest rates in Europe kept "low for longer" perhaps more so than in the US where the Federal Reserve has pledged to keep rates at rock bottom until 2013.
"While a systemic crisis, as in 2008, appears unlikely...the weakness in the banking sector and the weak macro backdrop suggests that a low growth period could persist for longer," the bank's strategists said in a note. "Risks of Europe slipping into a Japanese style macro environment could materialise. This scenario should be characterised by the ECB either easing rates or, at least, keeping them on hold for an extended period of time." One measure of banking risk, the iTraxx senior financials credit default swap index - which measures an average cost of insuring European banks's senior debt against default - is at all time highs around 265 basis points.