ECB WATCH: Rising Expectations of ECB Rate Cuts

By Nina Koeppen

Of DOW JONES NEWSWIRES

FRANKFURT (Dow Jones)--The surprise failure of a U.S. financial-system rescue plan has significantly altered interest rate expectations in the 15-country euro bloc.

The European Central Bank is now expected to slash rates in December, with expectations of an earlier cut building fast.

Overnight-index swaps, which represent market expectations of the average central-bank target rate, now imply that the ECB will slash rates by 25 basis points in December. Eonia futures currently reflect an over 50% chance of a rate cut already on Thursday, the date of the ECB's next policy meeting.

ECB President Jean-Claude Trichet may prepare investors for an early rate cut Thursday, when he briefs media on the bank's October rate verdict. At the very least, ECB watchers now expect Trichet to tone down hawkish rhetoric that has focused on inflation risk.

Even that would be interpreted as paving for a rate cut later this year, coming in stark contrast to only two weeks ago, when the market still saw an ECB waiting until next year to cut rates.

The failed U.S. $700 billion bank rescue package and a string of European bank failures this week also has increased the chances of coordinated rate cuts by leading central banks to take pressure off the international banking system, economists say.

"The ECB is under increasing pressure to cut interest rates soon. We now think it will reverse the 25 basis point increase from July soon, followed by a series of interest rate cuts towards the end of the year and beginning of 2009," said Joerg Radeke, an economist at U.K.-based think tank Centre for Economic and Business Research.

A host of special liquidity measures from the ECB has failed to halt the steady increase in longer-term Euribor rates.

The heavy usage of the ECB's overnight marginal lending and deposit facilities shows that interbank lending is still dysfunctional, with the ECB remaining practically the sole source of liquidity in an otherwise frozen interbank money market.

Overnight interbank rates, the rates at which banks lend money to each other, were at 4.59-5.11% at 0843 GMT, up from 4.30%-4.40% at 0700 GMT and 4.20%-4.70% in early trading Tuesday. Late Monday, overnight rates were 3.25%-3.75%. Wide spreads between the bid and ask levels often signal a reluctance to trade.

ECB data showed earlier in the day that one or more banks borrowed a total of EUR15.481 billion through its one-day marginal lending facility at 5.25%, and parked a total of EUR44.353 billion in its one-day deposit facility at 3.25%.

The data showed banks are depositing even larger amounts at the ECB's one-day below-market deposit facility, opting for lower-yielding deposits with the ECB than higher-yielding, but riskier, loans to other banks.

(Nina Koeppen writes about the European Central Bank and European economy for Dow Jones Newswires in Frankfurt. She has worked as a financial journalist for eight years, covering central bank policy, economics, foreign exchange, debt and equity markets. She can be reached at +49 69 29725 509 or by email: nina.koeppen@dowjones.com)

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(END) Dow Jones Newswires

September 30, 2008 06:41 ET (10:41 GMT)


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