IN the era of abnormal rates nowhere is more bizarre than Europe. Of 13 countries flashing negative yields, 12 are European. Switzerland’s two-year borrowing costs have dropped as low as minus 1pc, and even Italy, with one of the world’s highest debt-to-GDP ratios, has borrowed at sub-zero rates.

But this may be just the beginning. After years of central bank action designed to haul economies out of the mire — including about $12tn of asset buying, near-zero interest rates in the US and negative rates in Europe — investors seem convinced that further European stimulus is on its way.

The clue lies in Germany’s two-year borrowing costs, a mirror for eurozone short-term interest rate expectations.

Last month within a day of Mario Draghi, European Central Bank president, alluding to a key interest rate, Germany’s two-year yield had dropped from minus 0.26pc to minus 0.35pc.

Why would investors accept a yield so far below the ECB’s minus 0.2pc deposit rate and the cut-off point for assets the ECB will buy under its quantitative easing programme? Economists say it can only mean a 10 basis point rate cut has been priced in.

Economists say a 10bps cut to the ECB deposit rate must have been priced in

“The ECB has explicitly (re-)opened the door to further cuts in the rate applied to its deposit facility,” writes Frederik Ducrozet, economist at Pictet.

Investor expectations can be mapped by where they think overnight lending rates will be in Europe. In six months’ time markets put the overnight rate at minus 0.28pc.

RBS, Deutsche Bank and BNP Paribas agree that the ECB may be willing to drive rates deeper into negative territory as early as December.

“This is not just about the possibility of a rate cut,” says Giles Gale, head of European rates research at RBS. “It’s also the chance of QE extensions.”

In response a rally in European bond markets has extended the universe of negative-yielding government bonds.

“The ECB clearly has a bias to do more and will very likely do more,” says David Owen at Jefferies, who expects yields on government bonds in southern European countries to draw closer to those of Germany before the end of the year.

Negative rates remain a strange phenomenon. When QE was first used as an experiment by central banks, one of the explanations given was that interest rates had already been cut close to zero and had nowhere left to go.

Yet the ECB is one of four big central banks to have lowered policy rates into negative territory, along with Denmark, Sweden and Switzerland. The plan is that negative deposit rates encourage banks to reduce excess cash and buy alternative assets, easing the cost of borrowing for companies and individuals.

However, for investors negative yields present an odd scenario: they swallow a loss if they hold debt to maturity.

Michael Hartnett, chief investment strategist at Bank of America Merrill Lynch, calls the bull market a ‘game of Jenga’ that could collapse if further QE in Europe or interest rate rises in the US lead to volatility.

John Bilton, head of multi-asset strategy at JPMorgan Asset Management, says there is a palpable tempered risk appetite in spite of central bank hints, thanks to the summer volatility.

The ECB says its plans are working and that purchases of bonds are thawing credit markets and spurring investors to take on risk. But eurozone inflation remains way off the target of nearly 2pc and central banks elsewhere are sufficiently concerned about low global growth and inflation to hold off raising rates.

In quick succession the People’s Bank of China has cut rates, the ECB and Bank of Japan have suggested further easing is possible, and Sweden has announced additional QE. The US Federal Reserve has opted to hold rates so far, although Janet Yellen, its chair, said on October 5, a December rate rise remained a ‘live possibility’.

If the ECB takes the plunge, investors will look across to neighbouring central banks to respond with their own cuts.

“There’s every chance that an ECB rate cut will not be the last,” says Mr Gale. “Nega­tive rates were considered impossible until they happened. If rates are cut to minus 0.3pc and there are no ill effects, then why wouldn’t minus 0.4pc be on the table?"

Published in Dawn, Business & Finance weekly, November 9th, 2015

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