LONDON Short-term euro zone interest rates are pricing in a rising chance that the European Central Bank may ease monetary policy further later this year as the sovereign debt crisis intensifies and the economic outlook worsens.
Surveys showed on Monday the euro zone's private sector slump deepened at a faster than expected pace in April, dampening hopes that the bloc may come out of recession any time soon.
The release adds to fears that the austerity measures planned in vulnerable economies such as Italy or Spain may simply make it harder to raise revenue to repay debt. Investors are slowly turning their heads to the ECB again for measures to mitigate the crisis.
Forward euro overnight Eonia rates dated on future ECB rate-setting meetings this year have fallen in recent days, implying a further cut in the ECB's benchmark rate from its record low 1.0 percent, or some other additional official action to drive down borrowing costs. September and October Eonia rates briefly fell below 30 basis points on Monday, 5 bps lower than the May Eonia.
"It reflects the underlying bias of the market which is towards the ECB likely to do something down the line," FXPro chief economist Simon Smith said.
The Eonia curve has been largely flat at 34-35 basis points since the ECB injected around 1 trillion euros ($1.3 trillion) into the banking system because markets had largely expected the ECB to stand back and watch for a while.
Commerzbank rate strategist Benjamin Schroeder also takes the recent fall in Eonia rate forwards dated towards the end of the year as a sign that markets now think the ECB's stand-back stance may not last as long as previously thought.
"Markets are looking at ECB rate cuts down the road as the economic situation deteriorates with the austerity going on in euro land," Schroeder said.
"But I don't think the ECB will go down this path," he added, noting remarks by ECB policymakers, including President Mario Draghi, still suggesting a wait-and-see approach and putting the onus on politicians to fix the crisis.
Schroeder recommends a trade fighting the trend by paying forward Eonia rates below 34 basis points, the recent average.
As Spanish 10-year government bond yields flirt with 6 percent, a level which many analysts say is announcing a new wave in the euro zone crisis, money markets are showing signs of taking less comfort from the ECB's liquidity blanket.
A common gauge of interbank tensions, the spread between Libor rates and overnight index swaps, has stabilized in recent sessions at around 30 basis points, after narrowing by two thirds since the ECB's long term liquidity injections.
Another measure, the cost of swapping euro rates for dollars via three-month euro/dollar cross currency basis swaps, has also stabilized at around minus 50 basis points, pausing a narrowing trend since last November.
"I would expect (the two stress indicators) to nudge higher in the next couple of days," FXPro's Smith said. "The momentum we've gained from the ECB's three-year repos is pretty much followed through now.
"There's still a long way to go in terms of deleveraging and balance sheet adjustment, especially in Spain."
The Markit iTraxx index of default insurance for European senior financials, a measure that JPMorgan says is a more useful gauge of interbank stress than money market rates, hit its highest since mid-January on Monday at 256.38 bps.
($1 = 0.7571 euros)
(Graphics by Scott Barber; Editing by Ruth Pitchford)