Money markets ecb deposit rate cut priced by markets seen unlikely

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* Markets still price for cut in ECB deposit rate* But analysts see cut to zero unlikely* Could have detrimental effect on short-term marketsBy Kirsten DonovanLONDON, May 4 Markets are pricing in a cut in the rate the ECB pays banks to deposit funds overnight as a faltering euro zone economy raises expectations of further policy easing, but such a move may have a detrimental effect on financial institutions and short-term lending markets. The European Central Bank on Thursday neither signalled further monetary easing nor eliminated the possibility of more stimulus despite bank President Mario Draghi noting the uncertain picture for the euro zone economy. BNP Paribas calculates that markets are pricing in a 1-in-4 chance of a 25 basis point cut in the deposit rate - which banks receive when they park cash with the ECB - taking it to zero percent, or a 1-in-2 chance of a 12.5 basis point cut. This compares to a 33 percent and 66 percent implied probability prior to Draghi's press conference. The projections are based on the Eonia overnight indexed swap rate - a measure of future expectations for overnight market lending rates - at the time of December's ECB policy meeting. This is currently priced at around 27 basis points, around 7 basis points below current Eonia (interbank overnight) fixings, implying some measure of cut.

"A cut in the deposit rate could potentially stimulate banks to lend to the wider economy, but zero percent seems unlikely at this juncture," said RBS rate strategist Simon Peck."Markets have moved towards pricing a cut, and could go further with that, but whether it happens or not is another matter."The bank thinks the December overnight rate could fall further, to 20 basis points, as the market prices in a higher probability of a deposit rate cut, but analysts think it is unlikely the ECB's deposit rate would fall to zero."If they were to cut to 12 or 15 bps they're not forcing the banks to lend, it's more of gentle push. But if the deposit rate goes to zero it's a very different game," Peck added.

The ECB has pulled out all the stops to help the banking sector as investor and counterparty confidence crumbled with the escalation of the euro zone debt crisis on concerns over exposure to sovereign debt. The central bank's latest move was to pump over a trillion euros of three-year funds into the banking system, a notable step up in its policy to provide unlimited low cost funding. Banks are currently paid 25 basis points if they deposit money at the ECB overnight, a no risk option. If the rate is cut to zero this option disappears. Around 800 billion euros is currently being parked there and even though Draghi has said that it is not the same banks borrowing cash from the ECB as depositing it overnight, those banks that are keeping money at the ECB would lose income unless they were prepared to risk lending the money on.

"(Cutting the rate to zero) wouldn't really be in the spirit of what the ECB has been trying to do," said Credit Agricole rate strategist Orlando Green."It doesn't seem consistent, it might even be counter productive."Indeed, there are small signs that banks are being encouraged to lend anyway after the central bank's two three-year funding operations. The ECB's lending survey released last week showed banks expect to end the recent trend of tightening the rules for companies to obtain credit, although small and medium sized firms were struggling to get funding. Commerzbank rate strategist Benjamin Schroeder also said a cut in the deposit rate could have a knock-on effect on money market trading volumes and other shorter-term lending markets, such as the repo market."The "better" banks can still obtain funds from banks that have no recourse to the deposit facility at rates lower than the deposit rate. They then deposit the money at the ECB," he said."Those trades would vanish and the effect on turnover in money markets would be detrimental with no prices for short-term liquidity."

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