Money markets rate cut bets may be overdone if ecb buys bonds

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Aug 23 Euro zone implied interest rates may be too low if the European Central Bank buys Spanish and Italian bonds in large numbers to curb borrowing costs. Analysts are expecting further ECB rate cuts to help kick start the economy and encourage banks to lend cash but a concerted effort to lower and stabilise peripheral yields may be more successful in restoring confidence."One of the things the ECB tried to do was entice banks to lend," RBS rate strategist Brian Mangwiro said on Thursday."If the ECB to some extent reduces the downside risk coming from Spain and Italy, you could say the need to move the deposit rate into negative territory goes away."Forward overnight rates, show markets are pricing in a slim chance of a cut in the rate the ECB pays banks to deposit cash overnight -- now zero percent -- while a Reuters poll reflected expectations of a 25 basis point cut in the ECB's main refinancing rate to 0.5 percent in September.

The zero percent deposit rate means banks make no money from leaving cash at the central bank and has provided little incentive for them to lend to one another. A further cut in the rate would actively penalise them for leaving the money there. The ECB has said it might buy Spanish and Italian debt if the countries seek help from the euro zone rescue fund. Speculation this week has focused -- despite attempts by the ECB to quash it -- on whether the central bank will try to keep borrowing costs at a pre-determined level after media reports suggesting such a move was being discussed.

Central bank sources told Reuters on Thursday that while the ECB was considering setting a yield target, it would not make the levels public."(Bond buying) would make rate cuts less likely," said Peter Schaffrik, head of European rate strategy at RBC Capital Markets."(The ECB) have achieved low rates for the triple-A countries already, but the trick really is to bring the higher yielding bonds down. You could potentially still do something by bringing down the refinancing rate but it's not the main thing here."

RBS's Mangwiro said that if the ECB was a guaranteed buyer of Spanish or Italian bonds their market value would rise. As banks in the two countries have been heavy buyers of their own sovereign's debt after a spree earlier this year funded by cheap three-year ECB loans, that could also encourage banks to put their cash to work."The mark-to-market value of the bonds goes up and confidence among banks to lend to each other also improves," he said. Interbank Euribor lending rates have been hitting new lows daily on expectations the ECB will cut interest rates again as soon as next month. Forward overnight rates at 3.5 basis points in December are around 7 bps lower than spot, while Euribor futures increase in price until December, implying lower yields. But that may be pricing in too much if the ECB takes aggressive bond buying action and RBS suggests positioning for a flattening of the Euribor curve.

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