By Nick Mackie

FRANKFURT (MNI) – Money market reaction to the European Central
Bank’s decision Thursday essentially abandoning its tightening bias has
been extremely dovish, and short-term rates are now pricing in a
potential ECB cut as early as November.

The forward overnight Eonia interest rate curve is discounting a 25
basis point rate cut between November and January, and another one by
mid-2012.

Divyang Shah of IFR Markets said the new signal emanating from the
ECB paves the way for the central bank to cut rates should the economic
outlook or conditions in the financial sector deteriorate further.

However, the ECB need not feel pressed to cut rates straight away,
since the market has already determined rates should be lower than they
are and is thus providing de facto monetary loosening.

“It is the market rates that matter more than the refi rate,
although the refi rate does dictate the cost of getting liquidity from
the ECB,” Shah argued.

Forward Eonia rates have been trading not only well below the refi
rate, but also below the standing facility deposit rate, which
effectively sets a floor on spot rates.

There had been speculation ahead of Thursday’s Governing Council
meeting that the ECB might opt to widen its rate corridor by cutting the
deposit rate, in order to make it unattractive for banks to simply
re-deposit funds they have just borrowed from the central bank.

The bottom end of the rate corridor has been as low as 0.25% in the
past, so there is ample room for it to go lower.

ECB President Jean-Claude Trichet said that the Council had
discussed the issue of the corridor but concluded it should be left as
is for the time being.

He noted that tensions within the inter-bank lending market were
exerting downward pressure on Eonia.

“This is an equilibrium which is not particularly wished for by us
but it is understandable when you have a strong request for liquidity,”
Trichet said.

Shah said it was “positive that the ECB has sent the signal that it
is willing to respond with a rate cut and thus allow money market rates
to trade further lower should this prove to be necessary.”

However, with E172 billion being parked by banks in the ECB’s
overnight facility this morning, it is clear that tensions in inter-bank
money markets remain elevated.

With the end to the ECB’s tightening bias, markets should feel a
further cloud has been lifted from gauging directional bias, but as Shah
points out, nothing should be taken for granted.

“Without a trigger the ECB will be happy to maintain the current
stance of allowing money market rates to continue to trade sharply lower
than the refi rate,” he predicted.

–Frankfurt newsroom +49 69 72 01 42; e-mail: nmackie@marketnews.com

[TOPICS: MT$$$$,M$$EC$,M$X$$$,M$$CR$,MGX$$$]