Euro area money market rates: Depo rate cut expectations have been the main driver

After last week's sell-off, probably related to some profit-taking following the end-of September rally, euro short rates have dropped again over the past few days. As of the time of writing, the 1y Eonia has dropped to a record low of -18.5bp, and the 1y1y Eonia forward has moved back to -17.5bp after having sold off to -14.5bp last week. The move is related not only to improved liquidity outlook on expectations of more QE-related easing measures, but also to rising expectations of a depo rate cut in the coming months. The weakness of US data has supported the view that the Fed could stay on hold this year, and this has likely fuelled expectations of ECB reducing the floor of its monetary policy corridor to counteract a possible appreciation of the euro as a reflection of a dovish Fed.

The current level of the ECB-dated Eonia forward rates is consistent with about 50% chance of a 10bp cut and about 25% chance of a 20bp cut at the June 2016 meeting (assuming an Eonia fair level averaging depo +5bp during the reserve period in both cases). No depo rate cut is priced in for the October meeting, but the December meeting has about a 15% chance of a 10bp cut and an 8% likelihood of 20bp cut (assuming Eonia bottoms at depo +5bp, on average, in the reserve period in both cases)

"We expect the ECB to remain dovish and not to dismiss the current expectations of depo rate cut, we would regard any reversal of the current policy rates expectations after the October meeting as unlikely", notes Barclays.

Given the recent rally, some sell-off on short rates could happen, but it would be driven by profit-taking, not by a change in expectations. As long as there is uncertainty on the timing of the beginning of the Fed's hiking cycle, with the risk of euro appreciation in case of any delay, markets will continue to discount the possibility of a depo rate cut.