By Ana Nicolaci da Costa
LONDON, July 24 (Reuters) - The European Central Bank's 'forward guidance' has proven only partially successful in calming markets and offsetting the fallout from the U.S. Federal Reserve's plans to slow stimulus.
Bets on when the ECB will begin hiking interest rates again have been pushed back by around three months since it broke with tradition on July 4 by declaring it would keep interest rates at record lows for an extended period, prices show.
The unprecedented move came in response to market volatility that took hold after the Fed set out a plan in June to begin slowing the money-printing that has helped support asset prices.
But investors still expect an earlier monetary tightening than was priced in before the Fed hinted in late May it would start to 'taper' stimulus.
'They have managed to contain expectations but your conclusion on the failure or success of forward guidance by the ECB depends on your bias,' said Jerome Saragoussi, rates and volatility strategist at Deutsche Bank.
'One could argue it has been a success because they have effectively managed to delay and reduce the policy normalisation process priced in by the market relative to pre-ECB meeting levels. At the same time, we are still far from the low levels we had in May on short forward rates, on money market slopes and volatility ... so they have not achieved anything remarkable.'
Eonia overnight lending rates and implied volatility rose in late June after Fed Chairman Ben Bernanke said the bank could slow the pace of its monetary stimulus later this year, sparking a broad market sell-off.
Both came off their highs after central banks, including the ECB, said monetary policy would stay loose. But they did not fully reverse the move, even after Bernanke said this month that tapering plans were not set in stone.
The ECB, which had previously insisted it would never pre-commit on future rate moves, did not specify what period its forward guidance was intended to cover, and its policymakers - who meet next week - have not made things clearer since.
The one-month Eonia forward curve suggests investors see overnight rates at 75 basis points by the start of the second quarter of 2016, Saragoussi said.
Assuming the Eonia rate will have gradually converged to the current refinancing rate level of 50 bps by that time - as banks pay back emergency loans they took from the ECB at the height of the debt crisis - forward Eonia rates suggest investors see the first 25 bps rate hike in April 2016, he said.
That is three months later than Eonia forwards were pricing in before the July ECB meeting, when they saw a rate hike in January 2016. But prices in mid-May had indicated monetary tightening was only expected in September 2016.
Signs the euro zone economy is recovering after an 18-month recession means there is little chance seen that the ECB will lower rates again, as it said it might do if needed.
'It's important to remember that the Fed didn't achieve its goal the first time it offered guidance,' said Anthony O'Brien, co-head of European rates at Morgan Stanley, noting that the Fed had gradually became more specific about its policy outlook, linking it more closely to the rate of unemployment.
'For the ECB, this is the first foray into it. The central bank will say what they think. If they are not happy with how the market reacts, they will strengthen it.'
Other analysts also said money markets had pushed back the timing of a rate hike by three months. O'Brien said it was priced in for March 2016 versus December 2015 before the ECB meeting, while in early May, the hike was seen in early 2017.
The move in forward Eonia was mirrored by changes in volatility implied by swaptions, which also shows markets are betting on a two-to-three-year 'extended period' of low rates.
Volatility as implied by three-month options on five-year euro interest rate swaps, reflecting the expectation of volatility over the next five years, was at 65 basis points. That was down from 96 basis points before the ECB's July meeting but still above 47 basis points in mid-May.
Meanwhile, the change in implied volatility on three-month swaptions is seen peaking between the two- and three-year tenors , which analysts say indicates investors see a shift in ECB monetary policy in that period.
Volatility, as implied by three-month options on two-year and three-year euro interest rate swaps was at 53 bps and 62 bps respectively. That 9 bps jump is three times the gap between three- and 10-years. http://link.reuters.com/gyh89t
Investors enter euro swaps when they want to hedge against interest rate risks and use options when they are not fully confident about their rate views. The greater the demand for options, the higher the implied volatility.
(Additional Reporting by Marius Zaharia; Graphic by Vincent Flasseur; Editing by Nigel Stephenson and Catherine Evans) Keywords: MARKETS EUROPE/RATES
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