By Anirban Nag and Emelia Sithole-Matarise
LONDON (Reuters) - Tumbling euro zone inflation has firmed up market expectations that the European Central Bank will be forced to ease monetary policy in the coming months, taking the shine off a resurgent euro.
October's fall in the annual rate of price increases to 0.7 percent took it way under the ECB's target of at or just below 2 percent. It raised the spectre of deflation in some areas and of a risk to the euro zone's nascent economic recovery.
Money markets, which were already pricing in the possibility of looser ECB policy in the coming year, now reflect an outside chance of a move in the next few months.
Indeed some big banks, including UBS, RBS and Bank of America/Merrill Lynch have said they now expect a cut next week when the ECB meets to discuss policy. A Reuters poll taken before the inflation data showed no expectation of a rate cut.
From the market's point of view, it really comes down to when rather than whether.
"The market is (now) pricing in that the ECB will ease policy further, probably on the liquidity side and perhaps a refi rate cut without moving the deposit rate into negative territory," said Benjamin Schroeder, a strategist at Commerzbank.
One-year Eonia rates hit a 3-1/2 month low on Friday, showing greater market conviction of ECB easing in the future.
One-year one-year Eonia, which show where one-year Eonia contracts are expected to be in a year, fell 5 basis points to 0.27 percent, its lowest since July.
Assuming liquidity conditions normalise in the next two years, this means the forward Eonia curve is almost fully pricing in a refi rate cut over the next 12 months.
The inflation data also pushed the euro off two-year highs on a trade-weighted basis and boosted demand for options to hedge against further losses.
One-month risk reversals - a measure of relative demand for options on a currency rising or falling - showed an increased bias for euro puts, or bets the currency will weaken. Just a week ago, there was a slight bias towards euro calls - or bets the currency would gain.
"The FX options market reacted violently to the euro zone inflation numbers," said Chris Turner, head of currency strategy at ING. "Suffice to say the prospect of a dovish ECB meeting next Thursday should limit euro/dollar topside."
A strong currency curbs inflation by cutting the cost of imports and a steady drop in prices raises the risk of growth-sapping deflation. Price stability is at the core of the ECB's mandate.
Some analysts believe that the ECB will wait to make a final decision until December, when its new staff economic forecasts come out, including inflation.
A rate cut would be the first since May, when the ECB lowered the refinancing rate to a record low of 0.5 percent.
It would hurt the euro's rate advantage over other currencies and make it less alluring for investors. It fell to a two-week low below $1.35 on Friday and has shed 2.5 percent since it hit a two-year high of $1.3833 on October 25.
The ECB tried to talk down the euro in February, when subdued inflation along with the euro at $1.37 prompted bank President Mario Draghi to flag risks to growth.
Any hint from Draghi the euro was hurting growth would prompt another sell-off in the single currency, traders said.
The ECB could also give banks another dose of cheap long-term loans, an option that could weigh on the single currency.
"Without further liquidity easing a rate cut would just be a cosmetic noise because 25 basis points would not get Spanish or Italian banks lending or growing here," said Lena Komileva, chief economist at G+ Economics.(Editing by Nigel Stephenson/Jeremy Gaunt)