Money markets hopes of ecb bond buying underpin trade

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* Hopes high ECB will restart bond buying this week* Only limited relief seen from such a move* Market prices in 50 pct chance of rate cut by year-endBy Kirsten DonovanLONDON, July 31 Markets are pricing in around a 50 percent chance that the European Central Bank will cut interest rates again this year but are likely to react badly if they have to wait longer than a couple of days for it to revive its bond-buying programme. ECB President Mario Draghi said last week the ECB would do "whatever it takes", spurring expectations that the central bank will reactivate the Securities Market Programme (SMP) at Thursday's policy meeting. The SMP - which the Bundesbank opposes - has been dormant for months but would be used to buy Spanish and Italian bonds in the secondary market. The prospect of this has pushed yields on bonds issued by the two struggling countries sharply lower, but the rally is showing signs of running out of steam.

"Some of the confidence generated by Draghi is already fading - you can see that in the fall in Bund yields today," said BNP Paribas rate strategist Matteo Regesta."To make sure the relief rally we've seen is not further interrupted, at the very least we need a reactivation of the SMP. An interest rate cut by itself would fall short of what the market is expecting. Money markets aren't expecting a cut in either of the ECB's two main interest rates this week, or the "bazooka" option of granting the euro zone's rescue fund a banking license, allow it to exchange bonds it buys for fresh cash from the ECB. The main refinancing rate is at 0.50 percent, while the deposit rate paid to banks who park cash overnight is at zero. A cut in the deposit rate is increasingly priced in from September onwards, which would mean it would turn negative.

"Speculation may be overdone," said Commerzbank rate strategist Benjamin Schroeder."There are complications with negative rates but with the comments from the ECB members, the speculation could still run further."The overnight Eonia rate, which is currently around 10 basis points above the deposit rate, is indicated at around 2 basis points by year-end, suggesting a deposit rate of around minus 10 basis points.

PROMISES Financial markets are looking for a clear policy response from Draghi at the ECB's Thursday policy meeting . Nineteen of 24 euro money market traders polled by Reuters said the ECB will soon resume bond buying."The bar has been raised very high for the ECB to deliver something," Schroeder said. But analysts said even another round of bond buying would be unlikely to stabilise markets in the longer term, although it might ease the next few weeks combined with a sharp drop in new bond issuance over the summer period."It won't offer lasting relief, but it would allow August to be relatively stable," BNP Paribas' Regesta said."The real bazooka, even without activation, would be to grant the (euro zone rescue fund) a banking license... Just the presence of this vehicle with unlimited firepower would bring some peace to primary and secondary markets but we're not going to get that this week."