Yield Forecast Update No bond sell-off this year

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1 Investment Research General Market Conditions 16 September 216 Yield Forecast Update No bond sell-off this year The ECB disappointed the market last week. Many market participants had expected further policy easing in the form of new interest rate cuts or an extension/expansion of QE. The ECB delivered none of the above and, if anything, was slightly more optimistic about the effects of its current policy programme. The ECB did, however, acknowledge a need to change the rules governing the instruments it can buy as part of its asset purchase programme. The issue has now been handed over to a committee, which is unlikely to present its recommendations until December. The ECB s wait-and-see stance, combined with Fed members rather hawkish rhetoric and a Bank of Japan apparently also hesitant to ease policy further, prompted a rise in global yields and a steepening of the 2-1Y and 1-3Y curves, thus hitting mainly the long end. So, do we face an extended period of higher yields? The past three years have witnessed two periods of rising global yields. In 213, yields rose on the Fed announcing a tapering of its asset purchase programme. In spring 215, German 1Y yields increased by almost one percentage point ostensibly due to a combination of the market concluding that the ECB s QE was more than fully priced in and bad positioning in the fixed income market. The latter should be viewed in light of the risk capacity of banks now being much lower than before. Hence, major market movements could be reinforced in either direction as there is no one to take the opposite position. We do not seem to be facing an extended period of higher yields The future intentions of central banks remain unclear and the market may well have been wrong-footed once again. Hence, we cannot rule out a repeat performance of the yield increases in spring 215, when very few market participants expected German 1Y yields to rise almost one percentage point within six weeks. However, our overall expectation is that global central banks will continue their expansionary monetary policies. We do not expect the Fed to raise interest rates this year especially in light of recent weak numbers for the US economy. Given the still very low level of inflation, we also expect the ECB to extend its comprehensive QE programme to run throughout 217 and not just until March. Furthermore, we believe global bond investors will take advantage of even minor yield rises to increase their positions and duration. While it may sound odd to many investors, a German 1Y yield in positive territory is a good deal. We generally maintain our forecast of long DKK and EUR yields being range-bound over the coming three-six months with a slight downside risk on a 3M horizon. However, we still see yields rising slightly on a 12M horizon as the Fed, despite everything, begins to raise rates and the market can begin to price the ECB ending its asset purchases by the end of 217. Quick links Eurozone forecast US forecast UK forecast Denmark forecast Sweden forecast Norway forecast Forecast table Policy rate outlook Country Spot +3m +6m +12m USD EUR.... GBP DKK SEK NOK year bond yield outlook Country Spot +3m +6m +12m USD GER GBP DKK SEK NOK Editors: Chief Analyst Arne Lohmann Rasmussen arr@danskebank.dk Assistant Analyst Nina T. B. Andersen nian@danskebank.dk Important disclosures and certifications are contained from page 1 of this report.

2 Contents and contributors Eurozone... 3 Macro Senior Analyst Pernille B. Henneberg perni@danskebank.dk Interest rates Chief Analyst Arne Lohmann Rasmussen arr@danskebank.dk US... 4 Macro & Interest rates Senior Analyst Mikael Olai Milhøj milh@danskebank.dk Interest rates Chief Analyst Arne Lohmann Rasmussen arr@danskebank.dk UK... 5 Macro & Interest rates Senior Analyst Morten Helt mohel@danskebank.dk Denmark... 6 Macro Chief Economist Las Olsen laso@danskebank.dk Interest rates Chief Analyst Arne Lohmann Rasmussen arr@danskebank.dk Sweden... 7 Macro & Interest rates Chief Analyst Michael Boström +46 () mbos@danskebank.com Senior Analyst Michael Grahn +46 () mika@danskebank.com Senior Analyst Marcus Söderberg +46 () marsd@danskebank.com Senior Analyst Carl Milton +46 () carmi@danskebank.com Norway... 8 Macro & Interest rates Chief Analyst Jostein Tvedt jtv@danskebank.dk Forecast table September 216

3 Eurozone forecast Euro-area GDP growth showed fairly solid GDP growth of.3% q/q in Q2 16, while the unemployment rate in July remained at 1.1%. Furthermore, initial survey indicators suggest fairly resilient economic conditions post the Brexit vote. However, we still mainly have observations for survey data for two months and little hard data covering the period beyond July. All in all, however, it seems that the impact on the euro area economy has been relatively limited. Headline inflation stayed unchanged at.2% y/y in August. At the September meeting, the ECB kept all its policy rates unchanged and maintained its monthly QE purchases of EUR8bn and still intends to end its purchases in March 217. The ECB reiterated that it continues to expect the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of the net asset purchases. All in all, however, it was a slightly more hawkish message than expected in the market. Despite the September decision to keep the QE purchase horizon unchanged, we believe the ECB will extend purchases by six months at the meeting in December. We expect this because of the lack of any upward trend in the underlying price pressure and the persistently low market-based inflation expectations. Related to this, we do not believe a rise in inflation later this year would be enough for the ECB to end QE purchases, as any higher inflation would be driven mainly by the higher oil price. Focus in the European government is now on how the ECB will handle an extension of the QE programme without running into problems with the different rules. The issue is that there is basically not enough German government paper to buy with the current rules. The ECB has said that a committee will look into how the purchase programme can be extended. Following the ECB meeting, we have seen slight upward pressure on EUR yields. However, given our view that the QE purchases will be extended at the December meeting, we do not expect a prolonged rise in yields for the next three months. However, we still see modest upward pressure on 1Y yields on a 12M horizon, as we still expect upward pressure on the long end of US yields in 217. Thus, on a 6M and 12M horizon, we still look for a modest steepening of the EUR curve for 2Y1Y and 5Y1Y. Additionally, we expect 3M Euribor fixings to stay around -3bp throughout the forecast horizon. Note, we have seen no effect on Euribor fixings from the higher USD Libor fixings. EUR Forecast summary EUR Spot +3m +6m +12m ECB.... 3M year year year year year year EUR swap curve German government bonds Swaprates 1. % bp Change,bp (rhs) 16-Aug Sep-16 3M Euribor 1Y EUR swap rates 3 16 September 216

4 US forecast We continue to believe that the Fed will not raise the federal funds target range this year. In Presentation US: 1 reasons why we believe the Fed will not hike this year, 14 September, we outline why we have this non-consensus view on the Fed. To summarise, GDP growth has slowed markedly to just around 1% q/q AR over the past three quarters (Chart 1 in the presentation above) and ISM activity indicators are at the weakest level since 21, suggesting that growth in Q3 may disappoint as well (Chart 6). Unemployment and underemployment rates have moved sideways for some time, suggesting there is still more slack left in the labour market (Chart 2), wage growth is still subdued (Chart 3) and PCE core inflation continues to run somewhat below the 2% target (it has only been at or above target for five months since 28 Chart 4). Also, we think it is an overlooked fact that the Fed has already tightened monetary policy equivalent to 33bp due to QE tapering and hiking expectations (Chart 8). In addition, most voting FOMC members have a dovishto-neutral stance on monetary policy, in our view (Chart 9). At the time of writing, markets have priced in just a 1% probability of a hike in September and a 6% probability of a hike in December. Although a December hike cannot be ruled out if we see a rebound in data, it is not our base case and we think US yields will move lower over the next 3M as markets price out the probability of a Fed hike this year. We anticipate 2Y and 1Y US yields declining to.7% and 1.6%, respectively, by year-end. As we still expect a Fed hike in H1 17, we expect US yields to climb up again in 3-12M as markets begin to price in a continuation of the Fed s hiking cycle. We expect 2Y and 1Y US yields to trade at 1.2% and 1.9% in 12M, respectively. Note that we continue to see USD Libor fixings moving higher due to the effects of the US reform. See also The US Money Market Reform: The Scandi angle, 9 August 216. We assume that the regulatory changes to the US Money Market will have a lasting effect on USD Libor fixings. Hence, we expect 3M USD Libor to stay relatively elevated for the next six months, despite our view that the Fed will not hike the Fed funds target range this year. USD Forecast summary USD Spot +3m +6m +12m FED M year year year year year year USD swap curve Government bonds Swap rates 2. % bp Change,bp (rhs) 16-Aug Sep-16 3M USD Libor rates 1Y USD swap rates 4 16 September 216

5 UK forecasts Soft economic indicators suggest that the UK rebounded in August after the initial deceleration in July, suggesting that the UK economy may avoid a Brexit recession. PMIs have rebounded sharply across sectors: the NIESR GDP estimate has been positive and consumer confidence is still at a relatively high level. As the economic data has been better than expected, we now expect quarterly GDP growth to stay positive during H2 16, i.e. we no longer expect a Brexit recession although the probability of a recession is still relatively high. Also, it is worth noting that the economy is still expected to slow markedly compared with pre-referendum growth rates due to Brexit uncertainty. However, we stress that uncertainty surrounding our forecasts is higher than usual as the Brexit withdrawal negotiations are set to begin early next year when the UK triggers Article 5 and we still await the release of hard economic data. For more details, see our presentation Post-Brexit Status UK may avoid a Brexit-recession as data have surprised positively, 13 September 216. As expected, the Bank of England (BoE) made no policy changes at the September meeting meaning that the Bank Rate was kept at.25%, the target for the stock of government bond and corporate bond purchases was unchanged at GBP435bn and GBP1bn, respectively, and there were no changes to the new Term Funding Scheme (TFS). Despite better economic data, the Bank of England left the door open for additional easing later this year. We still expect a 15bp rate cut from.25% to.1% in November but it is a close call and will depend largely on how data comes out. There is only about a 5bp BoE rate cut priced in for November; therefore, we think markets are too complacent about the probability of further easing. After yields on Gilts fell sharply on the back of the restart of BoE s asset purchase programme and expectations of further BoE easing, 1Y Gilts yields have increased from the.52% low in the middle of August to.9% currently. We expect UK yields to drop slightly in the autumn as markets begin to price in more BoE easing, the ECB extends QE and Fed hikes are priced out. GBP Forecast summary GBP Spot +3m +6m +12m Base rate M Government bonds 2-year year year Swap rates 2-year year year GBP swap curve 1.2 % bp Change,bp (rhs) 16-Aug Sep-16 3M GBP Libor rates 1Y UK swap rates 5 16 September 216

6 Denmark forecasts Growth in Q2 was only slightly weaker than in the previous quarter and employment growth has accelerated; therefore, the overall economic picture has brightened somewhat. However, productivity growth remains low and consumer spending seems to have slowed somewhat. A large drop in the price of cell phone services has pulled inflation down further but the government no longer plans to scrap the PSO tax on electricity in 217. Therefore, the overall outlook is unchanged. The Danish Central Bank did not need to intervene in the FX market in August. EUR/DKK has settled in the range of since early August at this level we do not expect DN to be active in the FX market. We expect DN to keep the rate of interest on certificates of deposits unchanged at -.65% on a 12M horizon. However, if the need to sell DKK in FX intervention accelerates, or if the ECB decides to cut its deposit rate further (not our main scenario), DN may opt to cut to -.75% a level we still view as the lower bound for the key policy rate in Denmark. Tight excess liquidity in the DKK money market has eased on the back of DN selling DKK in FX intervention and buybacks of government bonds. With further buybacks in the pipeline, the liquidity situation is expected to ease further in the coming months. This should maintain moderate downward pressure on Danish money market fixings. The Danish CITA money market rates and Cibor fixings have recently edged marginally higher along with EONIA rates, as the market now prices in a lower probability of further rate cuts from the ECB. The money market does not expect CITA rates to move above EONIA rates before spring 218. Our forecasts for the deposit rate and money-market rates are more or less in line with market pricing. However, we still believe that the significant Danish current account surplus will ensure that the Danish policy rate can stay below that of the ECB for the near future and in 218 and beyond. We expect the general hunt for yield in the wake of the stepped-up ECB QE programme to attract investors to the marginally higher yields in Denmark. We forecast that 6M CIBOR fixings will stay marginally below zero, while we expect 3M fixings to stay negative by some 2bp. We expect 1Y swap rates to rise lightly on a 12M horizon in line with EUR rates. Forecasts summary DKK Spot +3m +6m +12m CD REPO M M Government bonds 2-year year year Swap rates 2-year year year DKK swap curve 1.4 % bp Change,bp (rhs) 16-Aug Sep-16 3M Cibor rate 1Y DKK swap rates 6 16 September 216

7 Sweden forecast There are several signs that Swedish growth has shifted to a lower gear. Exporters face more headwind, which is less of a surprise considering sluggish global demand for investment goods. Perhaps a bit more puzzling is the fact that consumers have started to hold back too and retailers have become more worried about business going forward. Mandatory amortisation on new mortgage loans was introduced this summer and it appears that price pressures have abated both for owner-occupied flats and single-family houses. Inflation showed a steady upward trend in but so far this year, CPIF inflation has been stuck at around 1.5% indeed, excluding the effects of higher energy prices, the inflation trend appears to have turned down again. So far, the Riksbank has expressed satisfaction with the development of inflation but if it fails to tack another step upwards again (as we suspect), it is likely to become more concerned. The question is how the Riksbank will move forward when the current QE programme (purchases of government bonds) expires in December. Should inflation fail to rise further in coming months, with the ECB likely to announce an extension of its QE programme, the Riksbank is likely to consider an extension too. The problem is that the Riksbank is probably approaching the limit for how large a share of bonds it can buy without damaging market liquidity. To avoid distressed market conditions, it may have to consider other assets too. We see another repo rate cut below -.5% as rather improbable but at the same time, we see little reason to expect it to hike rates before end-217. Despite very low yields, we still see powerful forces pushing down rates. Growth has peaked, the pick-up in inflation is likely to be over and central banks, via QE, have taken command over market pricing. We have for a long time held the view that the Swedish yield curve is too steep out to five years, reflecting expectations of more rapid rate hikes than we regard as warranted. More recently though the 2Y/5Y curve has indeed flattened rather significantly and now looks more fair. The five-year swap rate close to zero probably has a rather limited downside, which is why we think that continued downward pressure on rates will result in a 5Y/1y flattening. Forecast summary SEK Spot +3m +6m +12m Repo M Government bonds 2-year year year Swap rates 2-year year year SEK swap curve 2. % bp Change,bp (rhs) 16/8/216 16/9/216 3M Stibor rates 1Y SEK swap rates 7 16 September 216

8 Norway forecast We expect Norges Bank to be on hold at the upcoming board meeting on 22 September. Norges Bank s June Monetary Policy Report guided towards a cut at the September meeting unless a major surprise on the upside should occur. Inflation has recently been significantly higher than expected by Norges Bank. Key economic data has been fairly strong. The market no longer expects a target rate cut in September. However, the market may have underestimated the probability of a target rate cut going forward. An unusually high spread between the 3M Nibor and the target rate may be a concern to Norges Bank. To keep the currency weak is a top priority for Norges Bank s board. Both factors suggest that Norges Bank should stick to the original plan and cut the target rate at the upcoming meeting. Norwegian inflation during the summer has been above target and significantly higher than expected by Norges Bank. Core inflation in August was 3.3% y/y down from an elevated 3.7% y/y in July. The high inflation seems mainly to be a delayed effect of the weakening of the NOK. Inflation will probably drop significantly going forward as the inflationary effect of the past weakening of the NOK fades. Wage-generated inflation is still very muted. That is, Norges Bank, being forward looking, could rightly defend a cut to the target rate at the upcoming board meeting, regardless of the recent high inflation numbers. The recent Regional Network report was significantly stronger than expected. The six- month forward looking index increased from.28 to.75, i.e. the highest level since September 214. The report confirms the recent strong PMI and production indexes. That is, the business cycle trough seems to be behind us and activity seems to be picking up slightly. The drag on total activity from the oil investment slowdown is reduced. The fiscal policy is expansionary. The fiscal budget for 217 is due to be released on 6 October. The recent economic slowdown is the perfect excuse for the government for releasing an expansionary fiscal budget ahead of the general election on 11 September 217. A current target rate of.5% seems to be the trough of this interest rate cycle as fiscal stimulus gradually kicks in and the drag on total demand from the oil investment downturn fades. However, Norges Bank will probably indicate that a cut in December cannot be ruled out at the upcoming board meeting. The dovish stance is motivated by the ambition to maintain a weak NOK. This weak NOK policy will probably prevail for some time, which suggests fairly stable interest rates spreads versus European peers going forward. Forecast summary NOK Spot +3m +6m +12m ON DEP M Government bonds 2-year year year Swap rates 2-year year year NOK swap curve 1.9 % bp Change,bp (rhs) 16/8/216 16/9/216 3M Nibor rates 1Y NOK swap rates 8 16 September 216

9 Forecast table Forecast table USD EUR * GBP NOK SEK DKK Horizon Policy rate 3m xibor 2-yr swap 5-yr swap 1-yr swap 2-yr gov 5-yr gov 1-yr gov Spot m m m Spot m m m Spot m m m Spot m m m Spot m m m Spot m m m Note: * German government bonds are used, EUR swap rates are used 9 16 September 216

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