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Interest Rate Limbo: How Low Will the European Central Bank Go?

Europeans are on alert this week, and with good reason.

Eurostat released a very disappointing report on consumer prices Tuesday morning, two days ahead of the European Central Bank policy meeting. CPI rose just 0.5 percent in May, below both the forecast and April's reading of 0.7 percent. This marks the eighth consecutive month Euro area inflation has been less than half the European Central Bank's stated target of 2 percent.

The ECB will announce its latest interest rate policy Thursday at 7:45 a.m. ET, and economists tracked by Bloomberg are forecasting a bombshell announcement: Negative deposit rates. As the Euro-area economy contracts, the ECB wrestles with following through on President Mario Draghi's July 2012 promise to "do whatever it takes." Lowering the ECB deposit rate below zero would effectively penalize banks for parking money, presumably sending a signal to Europe's bankers they need to make loans and support growth. Again, this is significant and it's one of several unconventional policies being discussed.

Mr. Draghi will hold a press conference at 8:30 a.m. ET to discuss his decision. To say he will receive a battery of questions is an understatement. Negative interest rates are virtually unprecedented since World War II.

We first highlighted the compression of European sovereign yields on May 8. Since then, they have fallen further.

As to how far they can fall, we observe a Swiss 10-year yield of just 0.73 percent as Swiss CPI hovers at 0.0 percent. Can neighboring countries' bonds follow suit? In light of today's data, we believe the answer is yes.

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