* Euro zone bond yields plunge as inflation falls to 0.7 pct
* Emerging market tension may add to deflationary pressure
* Markets expect the ECB to potentially ease policy further
* Some banks see an ECB rate cut as soon as next week
By Emelia Sithole-Matarise and Marius Zaharia
LONDON, Jan 31 Euro zone bond yields and money
market rates slid on Friday after an unexpected drop in
inflation intensified speculation the European Central Bank may
ease its policy in coming months.
Spanish 10-year yields fell close to the eight-year lows hit
earlier this month, while equivalent German, Italian, Belgian,
Austrian, Finnish, and Dutch yields hit their lowest in six to
Inflation in the euro zone fell to 0.7 percent in January
from 0.8 percent the previous month and compared with a forecast
of 0.9 percent in a Reuters poll. The figure is well below the
ECB's target of nearly 2 percent.
"This obviously raises the stakes for the ECB," said Ciaran
O'Hagan, rate strategist at Societe Generale in Paris.
"Last time around (ECB President) Mr Draghi said the low
inflation reading was an aberration to be corrected but it's
getting harder and harder to explain."
Money market rates suggest investors expect the ECB to hold
fire at its meeting next week: forward overnight bank-to-bank
euro lending rates dated for the February meeting, at 0.18
percent, are higher than the spot Eonia rate of 0.155 percent.
The downward trajectory of money market rates maturing
beyond February, however, indicates expectations the ECB may
ease its policy later this year. The biggest declines - up to 5
bps on the day - were seen in Eonia rates from May to November -
all trading at or around their lowest since mid-2013.
"The market is clearly expecting something from the ECB
either a rate cut or something on the liquidity side," said
Jean-Francois Robin, head of rates strategy at Natixis. "That
might be the big danger here if the ECB does nothing maybe
market reaction might be a bit violent in this regard.
Some banks - such as RBS and Deutsche Bank - predict prompt
action from the central bank. RBS economist Richard Barwell
forecast a cut in the main refinancing rate to 0.10 percent from
0.25 percent next Thursday, with the rate the ECB pays banks for
holding their cash overnight remaining at zero. Deutsche
economists see a 5-10 basis point cut in the three key rates,
including the marginal lending rate.
Benchmark 10-year Bund yields dropped 5 bps to
1.565 percent, a six-month low.
Of particular worry is that the outlook for inflation may
worsen if the sell-off in emerging markets continues.
There are several channels through which this could happen:
tumbling currencies in the developing world could lead to
cheaper imports, a slowdown in demand from emerging markets
could push some euro zone prices lower, while investment flows
into the euro zone could strengthen the single currency.
This could partly explain why Spanish and Italian bonds have
shown resilience this week even during the most intense bouts of
selling in emerging markets, having in past years shown
vulnerability to shifts in global risk appetite.
"The EM (emerging market) developments are ... good news for
the euro zone periphery," rate strategist Christoph Rieger wrote
in a Commerzbank weekly note.
"Near-term uncertainty could lead to flows out of EM into
euro zone countries ... Moreover, the likely slowdown of demand
from some EM ... further weighs on inflation expectations, which
should spur speculations about the ECB response."
Spanish 10-year yields were last 4 bps down on
the day at 3.67 percent, having fallen as low as 3.653 percent,
within a whisker of an eight-year low hit earlier in January.
All euro zone yields fell by up to 8 bps, apart from those of
Greece - whose debt markets are heavily influenced by investors
exposed mainly to emerging markets - which were flat.
Analysts said the fact that peripheral yields fell after the
lower inflation data could be a sign that investors still saw a
very reduced risk of deflation in the euro zone.
Deflation could have a negative impact on peripheral debt
markets, as it would increase their debt burden in real terms
and would hurt their economic growth prospects.
"Diminishing price pressures are a double-edged sword for
the periphery," Rabobank senior rate strategist Richard McGuire
said. "We would argue that disinflation is positive for the
periphery - higher odds of ECB stimulus - but deflation is
negative - increasingly onerous debt burdens in real terms."