UPDATE 1-Investors raise ECB rate cut bets coronavirus fears bite

Investors are pricing in an increased chance the European Central Bank will cut interest rates sooner rather than later, reflecting heightened fears that coronavirus will spread and hit the eurozone economy hard.

A fourth person infected with the coronavirus has died in Italy, officials said on Monday, as the government struggled to contain an outbreak of the illness. As new cases rose in South Korea, Iran, and Italy, fuelling concern that the coronavirus outbreak in China will grow into a pandemic, investors started to price in greater chances of a near-term rate cut by the ECB.

Eonia money market futures dated to the ECB's July 2020 meeting show about 5 basis points of rate cuts are now priced in, up from 3.5 bps a week ago. That equates to roughly a 50% chance of a 10-bps cut versus 35% last week. It marks a turnaround from the start of 2020 when a stabilization in data had led to a view that the ECB might be encouraged to start raising rates from next year.

The U.S. fed fund futures signaled more rate cuts later this year and a near 20% chance of a cut next month. With Italy, the euro zone's third-biggest economy, shutting schools, universities, museums, and cinemas in its worst-hit areas, analysts said a rate cut may do little to shore up economic growth.

But they added that because the ECB was running out of ammunition, a rate cut remained one of the best options available. "There's plenty of arguments out there for why the ECB cutting rates from current levels won't do much to stimulate the economy," said John Davies, G10 rates strategist at Standard Chartered in London.

"The reality is that the central bank policymakers cannot be seen to do nothing. The ECB can cut rates or do more QE (quantitative easing), but can it do more QE without changing the parameters that are in place? So then a rate cut becomes the easy path." The ECB cut rates in September when it also announced that it would resume asset purchases -- a decision that exposed deep divisions on the ECB governing council. Concern about the bad effects of below-zero interest rates has also risen in recent months.

Against this backdrop, money markets do not price aggressive easing from the ECB -- Eonia futures price in roughly a 70% chance of a 10-bps cut by the end of the year. "The hurdle for a rate cut is pretty high given a reluctance to ease policy during a policy review and concern about the negative side effects of negative rates are growing," said Chris Scicluna, head of economic research at Daiwa Capital Markets.

The ECB currently undertaking a wide-ranging policy review.