LONDON (Reuters) - A year from the first anticipated rise in euro zone interest rates since 2011, markets are betting that a slowing global economy will hamper the European Central Bank’s efforts to lift rates significantly away from crisis-era levels.
The ECB is expected to end its 2.6 trillion euro ($3 trillion) monetary stimulus scheme at the end of this year and has signalled it will keep interest rates unchanged until late-2019 to support economic growth.
One 10-15 basis-point hike in the ECB’s minus 0.40 deposit rate is priced in for the end of 2019, judging by the difference between the overnight and forward Eonia rates — bank-to-bank interest rates for the euro area that provide some indication of how investors view the ECB rate trajectory.
Forward Eonia rates for 2020, suggest a further 30 basis points worth of tightening is anticipated, which would bring the deposit rate to around zero percent.
“The market is pricing in a zero deposit rate in two years’ time, which is quite gloomy,” said Martin van Vliet, senior rates strategist at ING in Amsterdam.
“In five years’ time, the forward (Eonia) curve points to a very gradual uplift in the depo rate to close to, but still below 1 percent.”
Van Vliet said this indicates investors are partly priced for an aborted ECB rate hike cycle. Or they believe the neutral policy rate in the euro zone — the interest rate level that neither restricts nor stimulates the economy — is likely to stay negative.
This is significant because it means the ECB’s room to use interest rate cuts as a tool to combat an economic downturn will be limited, suggesting it may have to turn to quantitative easing again.
The Fed on the other hand has been raising rates since late-2015 and is set deliver this year’s fourth rate hike in December.
Major central banks, including the ECB, pushed interest rates to record lows or negative territory in the wake of the global financial crisis to fight deflation and stimulate weak economies. The challenge they now face is to return interest rates to “normal” levels before growth slows again.
Economic conditions and inflation are likely to be strong enough to allow the ECB to kick off its tightening cycle next year, economists say.
But what happens after this is less clear with turmoil in Italy, global trade tensions and volatility in world stocks already prompting investors to push expectations for the timing of a first ECB rate hike to December from September 2019.
Recent data has disappointed and many economists expect the ECB to lower its growth forecasts in December.
“There appears to have been another false-start on ECB tightening expectations,” Steven Major, global head of fixed income at HSBC, said. He added in a note that market pricing for ECB rate hikes suggests scepticism regarding the wage growth and rise in headline inflation talked up by the ECB.
A closely-watched market gauge of long-term euro zone inflation expectations, the five-year, five-year breakeven rate has risen from one-year lows hit last week. But at 1.69 percent, that rate remains well below the ECB’s near 2 percent inflation target.
A slow start to a tightening cycle from the ECB would not come as a surprise — there was a one-year gap between the U.S. Federal Reserve’s first and second interest rate hikes.
The end of ECB chief Mario Draghi’s term next October also throws some uncertainty into the rate-hike timing.
The problem for the ECB is that its tightening cycle is likely to kick off just as the U.S. economy is tipped to slow - potentially signalling a pause in Fed rate hikes.
“For 2020, two rates hikes are conceivable but that’s probably the length of the ECB’s window,” said Andrew Bosomworth, a portfolio manager at PIMCO, one of the world’s biggest bond funds.
“The ECB will be able to go it alone for a while because of firm domestic demand but somewhere down the line, slower growth in the U.S. will feed through to slower growth in Europe and the ECB will probably not be able to deliver what’s been priced in,” he added.
Reporting and graphics by Dhara Ranasinghe; Editing by Sujata Rao and Richard Balmforth