By Marius Zaharia
LONDON (Reuters) - A year after Mario Draghi said European Central Bank interest rates had reached bottom, euro zone money markets are discounting a fair chance they could be lowered again - regardless of rising interest rates across the Atlantic.
The low bank-to-bank lending rates further highlight the divergence of monetary policies in Europe and the United States, where markets see a one in four chance the Federal Reserve may hike rates for the first time in a decade on Thursday.
Analysts calculate the probability that markets attach to another ECB rate cut at about 20 percent. But even the bias in direction shows unusual defiance of Draghi's policy guidance.
The new market leaning comes on the back of a weakening in the inflation outlook despite the ECB launching a trillion euro bond-buying program in March to pump new money into the economy.
Also, at the last ECB meeting, Draghi showed openness toward an expansion of the quantitative easing (QE) program. Vice President Vitor Constancio told Reuters in an interview that the ECB has scope to buy more assets. But no policymaker has signaled any new interest rate move.
Market rationale is a deposit rate cut from the current level of minus 20 basis points could be more effective than increasing QE in depreciating the euro, which has strengthened again in recent months, keeping inflation near zero.
"A deposit cut is a possibility," said Antonio Garcia Pascual, chief European economist at Barclays, adding though that it was more likely that the ECB would just expand its bond-buying program.
"The context for a potential deposit rate cut would be against the background of an appreciating euro which would be unwelcomed by the ECB because it would be unhelpful for inflation and for exports and the euro area recovery."
Factors behind moves in the euro are complex and go beyond the ECB's monetary toolkit.
Still, a quick look at the charts shows that after the ECB moved the rate it offers on overnight deposits into negative territory in June 2014, effectively turning it into a penalty for not putting money to work, the euro (EUR=) weakened by 5 percent against the dollar in the subsequent three months.
Another cut in September last year, after which Draghi said of interest rates that "we are at the lower bound, where technical adjustments are not going to be possible any longer," led to a further 5 percent, three-month weakening in the euro.
By contrast, the euro is 8 percent stronger than when QE started six months ago, although a Fed hike might hurt it again.
Analysts say expectations of a deposit rate cut are reflected in forward Eonia bank-to-bank lending rates.
One-month Eonia rates projected six-months to one-year into the future (EUR1MFOIS=R) are below -18 basis points, compared to the ECB deposit rate at -20 bps.
The gap between spot Eonia rates and the deposit rate has never been so low. On average, it has been 8 bps in the past two years and occasionally it has narrowed to 4-5 bps.
Alexander Wojt, European rates strategist at Morgan Stanley, takes a 5 bp spread as a starting point, implying expectations that the ECB deposit rate would be about 22 basis points in six-month's time. This translates into a 20 percent chance of another 10 bps cut.
"You could argue two things: one, that we are pricing in ...Eonia to trade closer to the deposit rate," Wojt said.
"The reason why we don't like that interpretation is that that's not the way Eonia has been behaving."
"An alternative interpretation, which we find more likely, is that ... markets have started to price some probability for a deposit rate cut."
Wojt said, however, that he considers the pricing too aggressive and recommends investors to bet against it.
In fact, the consensus remains firmly on the side of rates staying on hold.
"The wording by Draghi was clear when they did the last rate cut," said Commerzbank rate strategist Benjamin Schroeder.
(Reporting by Marius Zaharia; Editing by Toby Chopra)