By Marius Zaharia
LONDON, Feb 14 (Reuters) - Euro zone money market rates dropped on Thursday and were seen falling more in the near term after data showing the euro zone economy had slipped deeper into recession than expected.
The euro area's gross domestic product contracted by 0.6 percent in the last quarter of 2012, compared with a forecast of 0.4 percent. German, French and Italian data all came out below expectations.
A weak economic environment raised the prospect that banks could remain dependent on European Central Bank liquidity for longer than previously thought, keeping excess cash in the system abundant.
'The GDP data suggest the ECB is not going to be in any position to proceed with a liquidity exit strategy ... euro zone (banks) themselves are not confident in the situation,' G+ Economics managing director Lena Komileva said.
Euribor futures rose across the curve, implying expectations that three-month Euribor rates, their underlying asset, would in the future settle at levels lower than previously expected.
The December 2013 Euribor was 3.5 ticks higher at 99.59, implying the underlying rate - a gauge of market expectations on liquidity, the ECB's interest rate path and counterparty risk - was now seen settling at 0.41 percent at the end of the year.
That was still well above Thursday's settlement of 0.226 percent, implying markets expect the pace of the rise in short-term euro rates to slow down, but do not see the trend reversing.
Recent larger-than-expected repayments by banks of three-year ECB loans taken in late 2011 led to a rise in money market rates this year.
ECB President Mario Draghi at least paused the trend last week when he said he would monitor money markets to ensure policy remains 'accommodative'. He estimated that even after the initial repayments of the second of the ECB's loans, excess liquidity would not drop below 200 billion euros - the level at which overnight borrowing costs typically begin to rise.
One of the ECB's weapons against a fast rise in money market rates is a cut in the deposit facility rate to negative levels from zero. The bank's vice-president Vitor Constancio said on Thursday such a move was 'a possibility' but no decision had been taken.
Money markets have priced out that possibility earlier this year, but if data stays weak or the euro currency strengthens to levels that could cripple the economy, the forward euro overnight Eonia rate curve may price it back in.
'The data puts us back in the camp that the ECB needs to stay accommodative. A deposit rate cut is still somewhat exotic but it shouldn't be ruled out,' RBS strategist Harvinder Sian said.
He added that 1y1y Eonia forwards - an instrument that shows where markets expect one-year Eonia rates to trade starting in one year's time - could fall to 20 basis points from current levels of 38 bps, which were 5 bps lower than Wednesday's close.
(Reporting by Marius Zaharia) Keywords: MARKETS MONEY/
(firstname.lastname@example.org)(+44)(0)(207 542 0950)(Reuters Messaging: email@example.com)
Copyright Thomson Reuters 2013. All rights reserved.
The copying, republication or redistribution of Reuters News Content, including by framing or similar means, is expressly prohibited without the prior written consent of Thomson Reuters.