Yield Forecast Update Higher yields an H2 17 theme

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1 Investment Research General Market Conditions 13 February 2017 Yield Forecast Update Higher yields an H2 17 theme While we continue to see further upside for both 10Y Bund and 10Y US Treasury yields on a 6M-12M horizon, we expect no major yield changes over the next three-six months. Yields have fallen somewhat over the past month. We do not expect any further major downward correction in yields in coming months. We expect the market to start pricing an ECB tapering premium in H2 17 and to start discounting an increased Fed hiking pace in 2018 as Donald Trump steps up fiscal policy stimuli. We continue to expect a steeper 2Y-10Y EUR yield curve in While the ECB still has a tight grip on the short end of the curve, this is not the case for the 10Y segment. We expect 10Y Bund yields to rise to 0.90% and 10Y US Treasury yields to 3.0% by end Quick links Eurozone forecasts US forecasts UK forecasts Denmark forecasts Sweden forecasts Norway forecasts Forecasts table Following a sharp increase in both German and US yields in Q4 16, driven by global growth optimism, less fear of deflation and, not least, the election of Donald Trump as US president, the picture has been less clear so far this year. 10Y German Bund yield started the year by rising to almost 0.50% the highest level since early US yields also ticked up in January, with the 10Y Treasury yield briefly touching 2.50% in late January. However, 10Y yields have started falling again in both Germany and the USA over the past couple of weeks and are now trading at 0.30% and 2.35%, respectively. It is difficult to point to a single reason for the recent downward move in yields. However, as we wrote in the most recent version of Yield Forecast Update published at the beginning of January, markets not least, the US market entered the year being clearly positioned for higher yields. The US Commodity Futures Trading Commission (CFTC) publishes data for speculative short and long positions in both 2Y and 10Y Treasury Note futures. At the beginning of 2017, the data showed a record high number of speculative short positions in the futures and thus a clear expectation of higher yields. This picture has changed over the past couple of weeks, with, not least, the belief in higher 2Y yields but also expectations of higher 10Y yields weakening. Policy rate outlook Country Spot +3m +6m +12m USD EUR GBP DKK SEK NOK year swap rate outlook Country Spot +3m +6m +12m USD EUR GBP DKK SEK NOK Why have speculators lost faith in higher yields? There are several reasons for market optimism weakening at the beginning of 2017 relative to Q4 16. Firstly, political uncertainty in Europe has increased. The election of Donald Trump as US president has sharpened focus on the presidential race in France, where the Fillon scandal, with Republican candidate François Fillon apparently having hired his wife and children for fake jobs, has caused concern in the market of Marine Le Pen becoming new French president not least, because Le Pen has promised voters to call a referendum on French euro membership. While this has prompted safe-haven inflows into Bunds and Treasuries, French yields have increased significantly. 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 12 of this report.

2 Secondly, it seems that expectations had become stretched after a relatively long period of positive data surprises in both Europe and the US. This can be illustrated by the surprise indices, which show whether analysts are positively or negatively surprised by economic numbers. After surging to high levels, the surprise indices now seem to be edging down a bit. One of the economic numbers that have helped dampen yield increases is US pay rises, which fell back somewhat in December, reducing the likelihood of Fed hiking rates as early as in March We continue to expect the Fed to wait hiking until June 2017 and then to hike once again in December and three times in The market is still positioned for higher US bond yields but has stopped increasing positions; speculative net positions in the 10Y US Treasury note future Thirdly, we have seen some metal fatigue in stock markets, as investors seem to have begun losing faith in the Trump Administration introducing major tax cuts and infrastructure investments. Fourthly, one should not underestimate the effect of the ECB continuing its QE programme, buying government bonds worth EUR80bn a month. Most recently, the ECB has even decided also to buy bonds with coupons below its key policy rate of -0.40%. This has pushed German 2Y Bund yields down to a modest -0.80%. Fifthly, the need for collateral for repo transactions is currently prompting exceptionally high demand for German Bunds, pushing German yields further down. Source: Bloomberg French 10Y yields have increased, pushing German yields down Sixthly, the ECB has recently emphasised that is has absolutely no plans of starting any normalisation of its easy monetary policy. Source: Bloomberg Global surprise indices have levelled off Lower US pay rises have reduced fear of an imminent Fed rate hike Source: Bloomberg Source: Bloomberg Is the downward correction in yields over? From our viewpoint, the downward correction in yields that has unfolded over the past month is now coming to an end. While we do not expect any notable increase in yields within the next three to six months, higher yields will remain an H2 17 theme. There are several reasons why we do not anticipate yields falling further over the next few months. On the political front, President Trump has now announced that his long-awaited tax plan is underway. That news alone prompted a positive reaction from equity markets. In addition, we believe the market has now positioned itself for the political uncertainty in 2 13 February

3 France. On the other hand, the market is definitely not positioned for Marine Le Pen winning the French presidency. Our forecast is based on Ms. Le Pen losing out in the second round, in line with what all the opinion polls clearly indicate. As the market is only too well aware, the ECB will be tapering QE this spring, from EUR80bn to EUR60bn per month. Although the asset purchase programme is set to continue all through 2017, there is little doubt that fears of a negative inflationary spiral have fallen significantly, and euro area inflation did in fact climb to 1.8% in January. We also expect the global manufacturing recovery to continue over the next two quarters. ECB tapering set to become a market theme in H2 17 The ECB s actual asset purchases will probably not be the most important ECB factor in It will be equally important to see whether market focus will be on the ECB possibly tapering or ceasing its purchases altogether. Remember, US Treasury yields rose significantly in 2013 when the Fed announced the tapering of its QE programme. We still expect the market to start focusing on the prospects for tapering in 2017, and looking ahead to the turn of the year that should by itself serve to push up long-term German yields. However, we are convinced that the ECB will go through with its current QE programme. The question is what will happen in The pricing or fear of tapering and higher US yields are two of the reasons we continue to see a steeper 2Y-10Y EUR yield curve in The ECB still has a tight grip on the shortend of the curve but this is not the case for the 10Y segment. We expect higher 10Y EUR yields to materialise primarily on a 12M horizon, and we continue to target EUR swap rates at 1.30% and 10Y German yields at 0.90% on a 12M horizon. We also still expect US yield movements to feed through into euro yields. We expect the Fed to hike twice this year (June and December), but think the risk is skewed towards three hikes, which is also our call for All in all, our end Y US Treasury yield target is 3.0%, but with a certain upside risk February

4 Contents and contributors Eurozone...5 Macro Senior Analyst Pernille B. Henneberg Interest rates Chief Analyst Arne Lohmann Rasmussen US...6 Macro & interest rates Senior Analyst Mikael Olai Milhøj Interest rates Chief Analyst Arne Lohmann Rasmussen UK...7 Macro & interest rates Senior Analyst Morten Helt Denmark...8 Macro Chief Economist Las Olsen Interest rates Chief Analyst Arne Lohmann Rasmussen Sweden...9 Macro & interest rates Chief Analyst Michael Boström +46 (0) Senior Analyst Michael Grahn +46 (0) Senior Analyst Marcus Söderberg +46 (0) Senior Analyst Carl Milton +46 (0) Norway Macro & interest rates Chief Analyst Jostein Tvedt Forecasts table February

5 Eurozone forecasts At its December meeting, the ECB extended QE purchases until December However, given the latest upside surprise in inflation to 1.8% and the recovery in the European manufacturing cycle continue, we expect the tapering theme to become a market theme in 2017, although mainly in the second part of Note though, that President Draghi has maintained a dovish tone and reiterated that underlying inflation pressures remain very subdued. We continue to expect a steeper EUR yield curve 2Y10Y in The ECB still has a tight grip on the short-end of the curve, especially as the ECB is now buying below the depo rate at -0.4% but this is not the case for the 10Y segment of the curve, which we expect to be pushed up by higher US yields and a market slowly pricing in a greater probability of the ECB tapering QE purchases in We expect the higher 10Y EUR rates and yields to materialise primarily on a 12M horizon. We expect EUR rates to increase to 1.30% on a 12M horizon. We expect to see 10Y German yields rising to 0.90%. EUR forecasts summary 09/02/ Forecast Fcst vs Fwd in bp --- EUR Spot +3m +6m +12m +3m +6m +12m Money market Refi M Government bonds 2-year year year Swap rates 2-year year year EUR swap curve One month change 1.5 % bp Change,bp (rhs) 09-Jan Feb-17 3M Euribor 10Y EUR swap rates 5 13 February

6 US forecasts We still expect two hikes this year (in June and December) but believe the risk is skewed towards three hikes given Fed Chair Janet Yellen sounded more hawkish than we expected at the last FOMC meeting (see also FOMC Review: Hawkish Fed even without Trump s fiscal boost, 14 December) and as the US labour market remains tight. Given that Trump s economic plan is likely to boost growth mainly in 2018, we expect three to four hikes in US yields increased significantly in Q4 last year, supported by better economic data and expectations of more expansionary fiscal policy. However, recently US yields have edged lower again as the market seems to have priced in the global reflation theme and as the market has become a bit impatient waiting for how Trump will conduct fiscal policy during his term. Hence, it seems that yields have reached a plateau, which we expect them to stay close to, or slightly above, over the next 3M before moving higher again in 6M-12M. We still expect 10Y US treasury yields to reach 3.0% in 12M. We expect the yield curve to flatten over a 6M-12M horizon, as there is a limit to how high long-term yields can go, especially as 30Y US treasuries are already trading above the Fed s view on the so-called neutral rate. USD forecasts summary 09/02/ Forecast Fcst vs Fwd in bp --- USD Spot +3m +6m +12m +3m +6m +12m Money market Fed Funds M Government bonds 2-year year year Swap rates 2-year year year USD swap curve One month change 3.0 % bp Change,bp (rhs) 09-Jan Feb-17 3M USD Libor rates 10Y USD swap rates 6 13 February

7 UK forecasts We expect the Bank of England (BoE) to remain on hold for the next 12 months. While we think it is unlikely that the BoE will tighten monetary policy in a time of elevated political uncertainty, we think we need to see slower growth and/or higher unemployment before easing becomes likely again. At the February meeting, BoE Governor Mark Carney repeated that one of the reasons the UK has been resilient to Brexit uncertainties so far is due to the significant monetary easing by the BoE. Markets have priced in an accumulated 6bp rate hike this year, while a 25bp rate increase is priced in by end As such, we think the market pricing is too hawkish and we see little prospect of higher UK money market rates in the coming 12 months. We expect UK gilt yields to stay at current levels for now, before eventually moving higher in 6-12M, driven by higher yields in the US and Europe. We expect the 2Y10Y and 5Y10Y yields curve to steepen, as we expect the short end of the curve to stay low. UK forecasts summary 09/02/ Forecast Fcst vs Fwd in bp --- GBP Spot +3m +6m +12m +3m +6m +12m Money market Repo M Government bonds 2-year year year Swap rates 2-year year year UK swap curve One month change 2.0 % bp Change,bp (rhs) 09-Jan Feb-17 3M GBP Libor rates 10Y UK swap rates 7 13 February

8 Denmark forecasts Danmarks Nationalbank (DN) did not intervene in the market in January and it seems that the appreciation pressure on the Danish krone has abated for now. However, EUR/DKK is still trading close to the intervention level from December. We expect FX intervention to be DN s primary instrument for managing the EUR peg in 2017 and expect the rate of interest on certificates of deposit to stay unchanged at minus 0.65% in 12M. Given that we expect the ECB to continue with its QE programme throughout 2017 and into 2018, we expect the pressure for the Danish central bank to intervene in the market to intensify in If the political uncertainty escalates in the Eurozone, e.g. if Marine le Pen wins the French Presidential election and then calls a French referendum on the euro, we believe it is very likely that we could see a strong inflow into DKK and Danish fixed income assets, leading to a significant tightening of the yield and rates spread to Germany and the EUR swap curve. In our baseline scenario, we expect the Danish curve 2Y10Y to steepen in line with the EUR curve. We also expect the spread to EUR to remain stable to slightly tighter. DKK forecasts summary 09/02/ Forecast Fcst vs Fwd in bp --- DKK Spot +3m +6m +12m +3m +6m +12m Money market CD Repo M M Government bonds 2-year year year Swap rates 2-year year year DKK swap curve One month change 2.0 % bp Change,bp (rhs) 09-Jan Feb-17 3M Cibor rate 10Y DKK swap rates 8 13 February

9 Sweden forecasts Since the turn of the year the Riksbank has received little information that would warrant a change in policy. We expect no major announcements at the 15 February meeting. QE is set to continue with a total of SEK30bn until June. We expect that to be the final round of QE in Sweden. Over the next couple of months we expect only minor deviations compared to the Riksbank s inflation forecasts. Unless the SEK strengthens significantly from here, monetary policy is likely to remain on autopilot. As we approach the April meeting, a potential end of QE could emerge as a major market theme. Consequently, on a sixmonth horizon we look for higher long rates and steepening pressure. If the SEK were to strengthen excessively, we reason that the most likely response from the Riksbank would be to postpone the first planned rate hike. Over time an end to QE in government bonds should lead to ASW spreads tightening, especially in the 7-10Y segment that has probably been the most affected by QE bond purchases. SEK forecasts summary 09/02/ Forecast Fcst vs Fwd in bp --- SEK Spot +3m +6m +12m +3m +6m +12m Money market Repo M Government bonds 2-year year year Swap rates 2-year year year SEK swap curve One month change % bp Change,bp (rhs) 09/01/ /02/ M Stibor rate 10Y SEK swap rates 9 13 February

10 Norway forecasts At the recent policy meeting on 15 December, Norges Bank signalled no change in the target rate in 2017, from the present 0.50%. However, the bank s economic projections suggest a slight probability of a cut. In our view, only a surprise strengthening of the NOK is likely to trigger a cut short term. As assumed by Norges Bank, the Nibor over target rate spread declined significantly in January. The accommodating monetary policy has fuelled the Oslo housing market to the extreme. This appears to be a major long-run risk to financial stability and strongly suggests that Norges Bank should refrain, if possible, from cutting rates. The first upcoming major central bank event is the annual speech of the governor on 1 March. The above points may be addressed. Fiscal stimulus and an international reflation driven interest rate trend may increase the probability of 2018 interest rate hikes. We expect 5Y and 10Y yields to be stable versus peers in 2017, as the Norwegian economy is slowly improving but is still not out of the woods following the oil investment downturn. The positive outlook could trigger some inflow into the Norwegian government bond market and tighten the spread to Germany more than we forecast. NOK forecasts summary 09/02/ Forecast Fcst vs Fwd in bp --- NOK Spot +3m +6m +12m +3m +6m +12m Money market Deposit M Government bonds 2-year year year Swap rates 2-year year year NOK swap curve One month change 2.3 % bp Change,bp (rhs) 09/01/ /02/2017 3M Nibor rate 10Y NOK swap rates February

11 Forecasts table Forecast table NOK SEK DKK GBP EUR * USD Horizon Policy rate 3m xibor 2-yr swap 5-yr swap 10-yr swap 2-yr gov 5-yr gov 10-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 * German government bonds are used, EUR swap rates are used February

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