Yield Forecast Update Fed hike vs. possible further ECB easing

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1 Investment Research General Market Conditions 15 September 215 Fed hike vs. possible further ECB easing One of the most important events for the global fixed income market this autumn will be the FOMC meeting (see FOMC Preview: Almost there, 11 September) later this week. Although US data have moved in the right direction, we believe the greater uncertainty about global growth and the deflationary effects of the stronger USD and low commodity prices are likely to keep the Fed off the trigger at this meeting. However, given that the US unemployment rate has now fallen to the lowest level since April 28 and is now at the long-term level or NAIRU, we still expect the so-called lift-off at the December meeting. We also continue to hold the view that the US hiking pace will be significantly faster than currently priced in by the market, as we look for an average of 1bp in hikes per year in 216 and 217. However, we do not expect the market to price this scenario from day one and the Fed will probably also be eager to convince the market that it is in no hurry to hike rates. All in all, we continue to see some upside for US yields especially in the 2Y-5Y segment of the curve but we also expect 1Y yields to move higher. All in all, we see a flatter US curve 2Y1Y. Higher US yields will tend to push EUR yields higher but the effect will be felt primarily in the 1Y segment of the curve. The ECB is keeping shorter yields on a tight leash throughout the forecast horizon. However, we expect even the effect on the 1Y segment to be modest, especially as we now find it likely the ECB will extend QE purchases beyond September 216 (see Flash Comment: ECB will continue its QE purchases beyond September, 3 September). In our view, the ECB is still too optimistic about how fast core inflation will tick higher in 216 and eventually the ECB will have no option but to introduce more easing a first step would be to prolong monthly purchases. All in all, we now expect 1Y German yields to rise to % on a 12M horizon and we expect a small steepening of the German curve 2Y1Y and 5Y1Y due mainly to the spill over from the US in the long end. China and commodity concerns China has devalued the CNY and been forced to intervene strongly to avoid a further weakening of the currency. Chinese growth concerns have been very visible in global equity markets and we would normally expect a strong safe-haven support to US treasuries and German bonds in such a situation but the reaction has been muted. It probably reflects that the currency intervention by China and Asian central banks has resulted in a dramatic selling of liquid short-dated US and EUR bonds. However, given that China is important for global commodities and inflation expectations and potentially could delay Fed rate hikes further, we see China concerns as a factor that could push global yields lower from today s level. 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 We have assumed modest upward pressure on global commodity prices in 216. If we are wrong here, the effect on global yield (in both directions) could be quite severe. Lower prices could trigger a pause in Fed tightening, whereas higher prices might take away the pressure on the ECB to ease monetary policy further. Scandi rates more easing in Sweden and Norway As currency continues to flow out of Denmark, we still expect Danmarks Nationalbank to hike rates twice on a 6M horizon taking the deposit rate to -.55%. In Sweden, we expect a final rate cut before year-end. Finally, we expect Norges Bank to cut rates as a reaction to the fall in oil prices and oil investments. Editor: Chief Analyst Arne Lohmann Rasmussen arr@danskebank.dk Important disclosures and certifications are contained from page 1 of this report.

2 Contents and contributors Eurozone... 3 Macro Analyst Pernille Bomholdt Nielsen perni@danskebank.dk Interest rates Chief Analyst Arne Lohmann Rasmussen arr@danskebank.dk US... 4 Macro & Interest rates Senior Analyst Signe Roed-Frederiksen sroe@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 Senior 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.com Forecast table September 215

3 Eurozone forecast The euro-area recovery continues, but we are a bit concerned that the latest weakness in China and emerging markets together with the stronger currency will result in weakness in the manufacturing sector. We had expected stronger growth in investments but a potential negative sentiment impact is a risk to our outlook. Private consumption is still doing well supported by the very low oil price and continued progress in the labour market. The risk of deflation is back in the euro area and it is a close call whether inflation will print negative in September. Later this year we expect inflation to jump around 1 percentage point even if the oil price remains around the current level. Monetary policy and money markets ECB President Draghi was very dovish at the latest meeting at the beginning of September and based on this we expect the ECB to extend QE purchases beyond September 216. Our changed expectation comes mainly from the fact that the ECB now projects headline inflation to be only around.9% in Q2 16 and 1.2% in Q3 16 when the ECB is set to end QE purchases. In our view, the ECB will continue its purchases if inflation is around these levels and we continue to believe that the ECB is too optimistic on its outlook for core inflation, as slack in the labour market will still be a headwind to higher wage growth in 216. The Chinese devaluation kicked-off a month of financial uncertainty. However, we did not really see the expected support to German bunds. One reason might be that China and EM countries in the following weeks intervened heavily in the market to support their currencies selling both EUR and USD fixed income assets. However, as EM currencies have become more stable and as the market prices in further easing from the ECB we have seen downward pressure on 1Y yields once again. We expect to see modest further downward pressure on 1Y yields over the next three months. However, looking six and 12 months ahead, the spill-over from the US yields should result in a slight upward pressure on 1Y yields. In our view, the spill-over from the US will be felt mainly in the 1Y segment as ECB keeps 2y and 5Y yields in check with QE purchases, and we look for a clear steepening of the EUR curve 2Y1Y and 5Y1Y. Our yield forecasts for 1-year yields are on a six and twelve months horizon marginally above forwards, while two-year and five-year are more or less in line. Forecast summary EUR Spot +3m +6m +12m ECB M year year year year year year EUR swap curve German government bonds Swaprates 2. % bp Change,bp (rhs) 17-Aug Sep-15 3M Euribor 1Y EUR swap rates 3 15 September 215

4 US forecast The labour market continues to show improvement and the unemployment rate declined to a new low of 5.1% in August, which is the level of the June FOMC projected NAIRU. Other domestic data are also solid with private consumption, capital goods orders and housing activity trending higher. On the other hand, the manufacturing sector is slowing on a combined negative impetus from an inventory overhang built up in the first half of the year, a strong USD and weaker global demand. We thus expect GDP growth to slow in Q3 but to move higher again by year-end. Risks to the outlook have, however, risen, as the slowdown in China and EM in general could hurt US growth through several channels: a direct shock to exports (small), a negative impetus from a stronger USD (so far also small) and a sentiment effect on investments via increased uncertainty over global growth (unknown so far). PCE inflation remains low but we expect a gradual uptrend next year driven by rising wage growth, upward pressure from rising unit labour costs and the higher oil price. Monetary policy and the money market Although domestic economic data are moving in the right direction, the increased uncertainty about global growth and inflation over the past month is likely to keep the Fed off the trigger at the September FOMC meeting. We now expect the first Fed Funds rate hike to be delivered in December this year but stick to our view that the hiking cycle will be significantly faster than what is currently priced. We look for an average of 1bp in hikes per year. The hiking pace implied by money market forward rates remains very subdued with only two hikes priced for next year. Given our expected Fed Funds rate path, we project a steady increase in 3M USD Libor fixings over the coming year and our forecast for the fixing is well above forwards. Mixed economic data in coming months are likely to keep rates in check in the short term. As we move closer to the December FOMC meeting we see US rates trending higher, most significantly in the short end of the curve (2-5y rates). The upside to 1-year yields is dampened by the expected announcement of an extension of the ECB QE programme. We project a modest flattening of US curves (2-1y and 5-1y) around the time of the first Fed Funds rate hike and generally see rates above forwards across the curve. Forecast summary USD Spot +3m +6m +12m FED M Government bonds 2-year year year Swap rates 2-year year year USD swap curve 3. % bp Change,bp (rhs) 17-Aug Sep-15 3M USD Libor rates 1Y USD swap rates 4 15 September 215

5 UK forecasts The economic upturn in the UK is on track and we expect the UK to expand slightly above trend (.5% q/q) in the coming quarters. We expect growth to be driven mainly by domestic demand and in particular by private consumption as the outlook for private consumption remains solid. Private consumption is supported by a combination of higher employment, positive real wage growth for the first time since 29 and high consumer confidence. Inflation is expected to remain close to % in the coming months as the lower oil price and strong GBP weigh on inflation and one cannot rule out that inflation may turn negative. We expect CPI inflation to pick up to.9% in January and to increase further during 216 and eventually to reach 1.7% at the end of 216. Monetary policy and the money market There were no big surprises in the announcements from the Monetary Policy Committee (MPC) September meeting. As expected, there was another 8-1 split vote on whether to keep the Bank Rate unchanged or raise it immediately. The minutes indicate that most MPC members are not comfortable raising rates with the relatively high near-term uncertainty. We expect inflation to pick up in January when the base effects from the oil price drop in H2 14 disappear. This will open the door for the MPC to raise the Bank Rate in Q1 16. We expect it to deliver the first rate hike in February followed by two additional rate hikes next year, taking the Bank Rate to 1.25% by the end of 216. The market is pricing in the first full 25bp rate hike in July 216 and expects the BoE to hike less than twice per year going forward. We have lowered our forecast for 5Y and 1Y UK interest rates some 1bp and 2bp, respectively, in line with a mildly lower outlook for US and European 1Y rates due to the postponement of the first Fed hike to December and our expectation that the ECB will extend its QE programme. Given the high uncertainty about global growth, the Fed/ECB and the weak near-term UK inflation outlook, we expect UK interest rates to range trade in the coming months. Longer term, we still project substantial rises in UK interest rates driven by Bank of England rate hikes. As such, we expect interest rates in the -5Y segment to increase most with both the 2-1Y and 5-1Y curves flattening on a 12-month horizon. Our three-, six- and 12-month forecasts are still above forwards across the curve. 3M GBP Libor rates 1Y UK swap rates Forecast summary GBP Spot +3m +6m +12m Base rate M year year year year year year GBP swap curve Government bonds Swap rates 2.5 % bp Change,bp (rhs) 17-Aug Sep September 215

6 Denmark forecast Both consumption and exports were weak in Q2 and only falling imports and rising inventories kept GDP growth positive. It seems to have been temporary weakness though and the economy looks stronger in this quarter and going forward, depending on how the rest of Europe performs. Inflation fell to.5% y/y in August but underlying inflation pressures are increasing slightly and we still expect significantly higher inflation next year. Monetary policy and money markets Danmarks Nationalbank (DN) has made FX intervention purchases of DKK19bn since April and the FX reserve has fallen to DKK535bn. We expect DN to tighten the policy rate spread to the ECB when the FX reserve reaches a level of around DKK45bn, which was the level before the currency inflow in Q1. Given the current pace of outflow, this fits with a hike in the rate of interest on certificates of deposit (CD rate) by 1bp on a 3M horizon and probably another 1bp on a 6M horizon to minus.55%. However, the short-term moneymarket interest rate spread to the euro area has already narrowed and worked as an implicit rate hike. If the current spread to the euro area in short-term money-market rates stays at the current level, the risk is clearly that DN will not have to hike the CD rate as much or not at all - as we have put into our forecast. If the ECB steps up its bond purchases aggressively or cuts its deposit rate, it would have the same effect on policy rates in Denmark. Danish two-year swap rates have continued to edge higher over the past month as spreads have widened against the EUR as short-dated CITA rates and CIBOR fixings have been pushed higher by the tighter liquidity and rate hike expectations. Over the same period, 1- year swap rates have stayed more or less stable, with a spread to EUR that is now higher than seen before the currency inflow accelerated in Q1. Even though we forecast two independent Danish rate hikes, our forecasts are still below the forward market on a three- to six-month horizon, especially for 2Y and 5Y rates. Danish 1Y rates on a 12M horizon are pushed higher mainly on the back of higher EUR and USD rates, though we expect the spread to EUR to tighten slightly. Government bond issuance will resume by October and DKK1bn will be sold in Q4 and 216 in total. The resumption of issuance should improve liquidity in the Danish market and support a modest tightening versus EUR yields and swaps. 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 2. % bp Change,bp (rhs) 17-Aug Sep M Cibor Rates 1Y DKK swap rates 6 15 September 215

7 Sweden forecast The second estimate of Q2 GDP was even stronger than the first, showing 1.1% q/q growth (3.3% y/y). The well-behaved labour market reflects the positive growth environment. Seasonally adjusted unemployment has fallen from 7.6% in the beginning of the year to 7% and employment is rising at a healthy pace. However, just as in many other countries inflation remains low. Admittedly, the Riksbank s policy measure of inflation, CPIF (CPI less mortgage interest rates) has risen slightly. This is entirely due to the effects of a weaker SEK. Inflation pressures on domestically produced goods and services have so far showed no sign of picking up. Monetary policy and the money market On the back of recent declines in energy prices, the Riksbank lowered its inflation forecast for the coming year in the September forecast update but decided to keep its policy unchanged. There are two factors that deserve attention. First, Danske Bank expects the ECB to extend its asset purchase programme beyond September 216. Secondly, currency effects that so far have helped to dampen disinflationary pressures are abating. This makes it of vital importance for the Riksbank to avoid a strengthening of the SEK, something that depresses inflation again. Since the ECB is likely to step up monetary stimulus, the Riksbank is likely to follow suit. We expect the repo rate to be lowered by 1bp (to -.45%) in December, a level we expect to mark the bottom. The current asset purchase programme runs through December, by when the Riksbank will have purchased 135bn or 24% of the outstanding stock of nominal bonds. We expect the programme to be extended into 216 (probably another quarter). The swap curve has steepened relative to the government bond curve this year, something that appears logical given the fact that the Riksbank is a buyer of large volumes of bonds (with an average maturity just over five years). We expect this to prevail as long as QE continues. However, we see some downside potential near term in longer-term bond/swap rates. The Fed is expected to start hiking in December and very little is priced in terms of Fed hikes next year, maybe too little. If so, US rates will correct higher and this typically spills over to Sweden as well. So we are probably not far from the trough in longer-term bond/swap rates after all, which should lead to a steeper curve. 3M Stibor rates 1Y SEK swap rates Forecast summary SEK Spot +3m +6m +12m Repo M year year year year year year SEK swap curve Government bonds Swap rates 2.5 % bp Change,bp (rhs) 17/8/215 15/9/ September 215

8 Norway forecast The forward looking industry indicator of Norges Bank s Regional Network Report shows a slowdown of the oil industry in the wake of the oil price drop and excessive capacity investments in recent years. However, the slowdown is still limited to the oil industry and the oil-dependent south-west coast of Norway. Somewhat stronger international markets, and a weak NOK, continue to fuel traditional exports. Service industries enjoy expanding markets as household demand is fairly strong due to low interest rates. The recent labour market survey shows a steep increase in unemployment, as the work force expansion outpaces employment growth. The expected headwind of the private sector will probably trigger an expansionary fiscal budget proposal for 216 to be released on 7 October. Core inflation at 2.9% in August is above the inflation target of 2.5%, but the high reading is mainly due to a weak NOK during 215. However, wage generated inflation seems to be on the decline. Wage growth next year is expected to be below 3.%. i.e. real wage growth is set to be meagre going forward. Monetary policy and the money market Norges Bank s balancing act, i.e. too high core inflation vs curbing the oil industry slowdown, will probably tilt towards a cut in the target rate of 25bp to.75% at the board meeting on 24 September. The current inflation level is slightly higher than expected by Norges Bank. However, it reflects a deliberate policy of inflating of the economy in order to keep the NOK weak, i.e. facilitate the transformation from oil to traditional exports. Norges Bank probably sees the recent Regional Network Report as a confirmation that the current weak-nok policy is a success. Given that the market to a large extent already discounts a cut in the target rate at the upcoming meeting, it will suit Norges Bank well to deliver as expected. If Norges Bank cuts the target rate on 25 September, the market will most likely discount another cut during the autumn. In order to keep the currency weak, we do not expect Norges Bank to guide the market otherwise. We expect Norges Bank s bias to remain dovish. However, we believe that the diffusion of negative oil industry impulses into the general economy will be somewhat weaker than feared by Norges Bank. Therefore, we expect that Norges Bank will refrain for cutting the target rate below.75% this autumn. Hence, we will probably see the trough of the 3m Nibor already this autumn. We expect long-dated yields internationally to follow a moderate upward trend. Forecast summary NOK Spot +3m +6m +12m ON DEP M year year year year year year NOK swap curve Government bonds Swap rates 2.4 % bp Change,bp (rhs) 17/8/215 15/9/215 3M Nibor rates 1Y NOK swap rates 8 15 September 215

9 NOK SEK DKK GBP EUR * USD Forecast table Forecast table 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 15 September 215

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