By Anirban Nag and Emelia Sithole-Matarise
LONDON, Nov 1 (Reuters) - Tumbling euro zone inflation hasfirmed up market expectations that the European Central Bankwill be forced to ease monetary policy in the coming months,taking the shine off a resurgent euro.
October's fall in the annual rate of price increases to 0.7percent took it way under the ECB's target of at or just below 2percent. It raised the spectre of deflation in some areas and ofa risk to the euro zone's nascent economic recovery.
Money markets, which were already pricing in the possibilityof looser ECB policy in the coming year, now reflect an outsidechance of a move in the next few months.
Indeed some big banks, including UBS, RBS and Bank ofAmerica/Merrill Lynch have said they now expect a cut next weekwhen the ECB meets to discuss policy. A Reuters poll takenbefore the inflation data showed no expectation of a rate cut.
From the market's point of view, it really comes down towhen rather than whether.
"The market is (now) pricing in that the ECB will easepolicy further, probably on the liquidity side and perhaps arefi rate cut without moving the deposit rate into negativeterritory," said Benjamin Schroeder, a strategist atCommerzbank.
One-year Eonia rates hit a 3-1/2 month low onFriday, showing greater market conviction of ECB easing in thefuture.
One-year one-year Eonia, which show whereone-year Eonia contracts are expected to be in a year, fell 5basis points to 0.27 percent, its lowest since July.
Assuming liquidity conditions normalise in the next twoyears, this means the forward Eonia curve is almost fullypricing in a refi rate cut over the next 12 months.
The inflation data also pushed the euro off two-year highson a trade-weighted basis and boosted demand foroptions to hedge against further losses.
One-month risk reversals - a measure ofrelative demand for options on a currency rising or falling -showed an increased bias for euro puts, or bets the currencywill weaken. Just a week ago, there was a slight bias towardseuro calls - or bets the currency would gain.
"The FX options market reacted violently to the euro zoneinflation numbers," said Chris Turner, head of currency strategyat ING. "Suffice to say the prospect of a dovish ECB meetingnext Thursday should limit euro/dollar topside."
A strong currency curbs inflation by cutting the cost ofimports and a steady drop in prices raises the risk ofgrowth-sapping deflation. Price stability is at the core of theECB's mandate.
Some analysts believe that the ECB will wait to make a finaldecision until December, when its new staff economic forecastscome out, including inflation.
A rate cut would be the first since May, when the ECBlowered the refinancing rate to a record low of 0.5 percent.
It would hurt the euro's rate advantage over othercurrencies and make it less alluring for investors. It fell to atwo-week low below $1.35 on Friday and has shed 2.5percent since it hit a two-year high of $1.3833 on Oct. 25.
The ECB tried to talk down the euro in February, whensubdued inflation along with the euro at $1.37 prompted bankPresident Mario Draghi to flag risks to growth.
Any hint from Draghi the euro was hurting growth wouldprompt another sell-off in the single currency, traders said.
The ECB could also give banks another dose of cheaplong-term loans, an option that could weigh on the singlecurrency.
"Without further liquidity easing a rate cut would just be acosmetic noise because 25 basis points would not get Spanish orItalian banks lending or growing here," said Lena Komileva,chief economist at G+ Economics.
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