August 19, 2014 / 3:20 PM / in 3 years

Interbank, Bund rates hit lows as euro zone outlook dims

* Overnight Eonia hits low, Bund yields dip back below 1 pct

* Russia preps new sanctions as euro zone economy stagnates

* Traders see 50 pct of QE in next year

* Portugal yields fall as Fitch praises court ruling (Updates prices, adds new comments, data)

By John Geddie and Marius Zaharia

LONDON, Aug 19 (Reuters) - Euro zone money market rates fell to new lows on Tuesday and German Bund yields dropped below 1 percent as the region’s weak recovery kept up pressure on the European Central Bank to maintain its ultra-loose monetary policy.

With a new tit-for-tat sanctions between Russia and the West being discussed as the Ukraine conflict rumbles on, investors are growing increasingly certain that subdued growth and inflation will herald a prolonged period of low rates.

Money market traders now see an even 50 percent chance of an ECB asset-purchase programme, known as quantitative easing, in the coming year, a Reuters poll found on Monday. A previous survey showed only a one-in-three chance.

While investors see a long period of low price growth ahead, they expect the ECB to prevent the euro zone economy to fall into a Japan-like deflationary spiral.

“We are not willing to bet against the ECB doing whatever is necessary to avoid Japanese-style policy mistakes,” said Michael Krautzberger, head of European fixed income at BlackRock.

Yields on German 10-year Bunds - the benchmark for euro zone borrowing costs - fell back below 1 percent on Tuesday. They hit a record low of 0.952 percent last week.

The euro bank-to-bank overnight lending rate settled at a record low of 0.006 percent on Monday, helped by ample spare cash in the euro zone’s banking system, which currently stands at 134 billion euros.

The ECB cut all its interest rates in June and made new four-year loans (TLTROs) available to euro zone banks from September. It also injected liquidity into money markets by abandoning a tender to sterilise crisis loans.

But strategists say current market prices are starting to price in further policy easing ahead.


“Low rates are simply an expectation of continued ample liquidity from the ECB, certainly through the TLTROs but maybe down the line through additional initiatives,” said Lars Peter Lilleore, chief strategist at Nordea.

Forward money market rates are also at historic lows, pinned by September’s cash injection. Looking further out, Nordea’s Lilleore said rates for 2015 suggest there will have to be negative daily fixings.

“I wouldn’t exclude the overnight rate dropping below zero, but I find it difficult to see banks charging negative rates on unsecured lending,” said Benjamin Schroeder, a strategist at Commerzbank.

The ECB’s preferred measure of the market’s medium- to long-term inflation expectations shows that investors see price growth eventually hitting the ECB’s target.

The five-year, five-year forward breakeven rate, which measures roughly where investors see five-year inflation rates in five years’ time, stands around 2 percent.

But other measures are falling sharply.

Two-year breakeven rates, which measure inflation expectations by showing the difference between yields on inflation-linked and nominal bonds, were last minus 0.3 percent, having been positive a month ago.

“What has really driven the market here is poor macroeconomic data, probably compounded by the sanctions and the implication that this might have on economic activity,” said RBC’s head of European rates strategy, Peter Schaffrik.

Elsewhere on Tuesday, Portugal’s 10-year yields dropped 9 bps to 3.42 percent. Ratings agency Fitch said partial approval by the country’s constitutional court of expenditure measures reduced a key near-term risk and kept the country on track to hit fiscal targets. (Editing by Alison Williams)

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