Euro zone rate cuts? Money markets nudging that way

By Dhara Ranasinghe

LONDON (Reuters) - The euro zone's worsening economic picture, exacerbated by Brexit and global trade tensions, is pushing parts of the money market closer to pricing in interest rate cuts in the bloc.

The gap between two and three-year swap rates has narrowed in the past three months to around 8 basis points, close to its tightest since early 2017, according to Tradeweb data. A swap rate is a swap of a fixed interest rate versus a series of floating rates.

Three-year swap rates tend to be higher than two-year rates to reflect expectations for higher funding in the future. When the gap between the two moves closer to the point of inversion -- where two-year rates rise above three-year rates -- it is considered a worrying signal.

In fact, the last time the spread between the two came close to inversion was July 2016 -- just after Britain voted to leave the European Union, rattling world markets, and the European Central Bank ramped up monetary stimulus and slashed interest rates to fight deflation.

Tradeweb said the last time the front end of the swaps curve inverted was during the 2008 financial crisis, when central banks globally cut rates.

"The increasing flatness of the swaps curve clearly reflects the fact that the market is pushing the prospect of ECB policy normalization further and further into the future," said Richard McGuire, head of rates strategy at Rabobank in London.

"The downside risks to the euro zone economy have clearly intensified, and there are euro-specific as well as global reasons for that."

Such bond market signals are taken seriously by investors. When U.S. two-year Treasury yields rose above three-year yields late last year, it sparked concern that a bigger inversion of the U.S. curve -- considered a harbinger of recession -- was underway.

The U.S. bond curve has steepened since, as the Federal Reserve has indicated a pause in its rate increases.

In the euro zone now, money markets still predict an ECB rate hike, but they have pushed those expectations out to mid-2020. The bond curve has flattened, too, with ten-year German yields trading just above 0.10 percent and the gap between two- and 10-year yields at the narrowest in more than two years.

But the swaps curve is considered a "cleaner" indicator than cash bond markets, which are distorted by quantitative easing and bank regulation. For the swaps and bond yield curves to steepen back, markets will need to see renewed stimulus from the ECB. Many reckon that's on the way.

(Reporting by Dhara Ranasinghe; editing by Sujata Rao, Larry King)