New yield forecast ECBs soft tone postpones expected tightening to 2011

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1 Investeringsanalyse Marts New yield forecast ECBs soft tone postpones expected tightening to Latest market developments Generally speaking the economic data continue to point to a sustainable economic turnaround with relatively robust global growth. The US and Asia are leading the way, while the data out of Euroland have been a bit of a letdown lately. That said, confidence indicators for the manufacturing sector remain solid, especially with respect to export orders, and growth may well accelerate again in the coming months. The problems in Greece are beginning to slip off radar screens after the Greek government demonstrated a new resolve to implement necessary fiscal tightening measures. February s jobs report in the US indicated that underlying job growth is once again in positive territory. The good labour market numbers helped assuage market concerns about the sustainability of the upswing and boosted risk appetite. Equities have recouped their losses from the start of the year and rate spreads between Germany and southern Europe have narrowed once more. Increased optimism has helped send short rates higher, and the -Y curve has flattened on both sides of the Atlantic, though it remains very steep. Despite a modest increase, German short rates continue to trade at very low levels. The first rate hike from the ECB is not being priced in until summer next year. Macroeconomic outlook US indicators suggest a strong growth momentum going into. While we do not expect the impressive growth of Q to be repeated in Q, the growth rate should still be well above trend. That said, we believe that the pace of growth has peaked for now. Companies have almost closed the massive gap between production and demand that arose in the wake of the crisis, and further growth will have to come from rising demand. Moreover, fiscal easing will make a considerably reduced contribution to growth in compared with 9. Key points Long German yields have remained stable despite rising risk appetite and signs of the Greek debt problem being solved. Short rates have risen in recent weeks and the curve has flattened. We expect further curve flattening going forward. A soft tone from the ECB has led us to postpone the first rate hike to Q. We expect Nationalbanken to deliver more cuts in the current account and certificate of deposit rates in the coming weeks. The US is leading Euroland in the upswing and so the Fed will act before the ECB. We expect the first US hike in November. Yields are expected to rise on both sides of the Atlantic in. Next yield forecast scheduled for April. The key to a sustainable upswing is a turnaround in the labour market, which despite the economy growing we are still waiting to see. However, the latest indicators suggest that employment growth is just around the corner, and unemployment appears to have peaked in the autumn. Clarification of the labour market situation would boost confidence in the sustainability of the upswing and could therefore have a substantial impact on the market. Euroland seems to have lost some traction, though companies continue to make progress. Continuing growth in Europe s export markets, low inventories and now also the weak euro are the factors supporting industry. Investment is expected to pick up in the coming quarters, and private consumption will be helped by a stabilisation in the labour market, low interest rates and tax cuts Inflation is not giving much cause for concern in either Euroland or the US. Core inflation looks set to fall in the coming quarters due to low capacity utilisation and slowing wage growth. Headline inflation will be pushed higher by commodity prices, but nevertheless remain very modest. Senior Analyst Jesper Fischer-Nielsen jfis@danskebank.dk Senior Analyst Signe Roed-Frederiksen sroe@danskebank.dk

2 Central banks and bond yields The Federal Reserve has closed the majority of its extraordinary liquidity and credit programmes, and the remainder will expire by the end of H. The Fed will also wind up its mortgage bond purchase programme on March. As a step towards normalising the money market, the Fed is expected to re-establish the bp spread between the discount rate and the fed funds rate in the course of H. We are not expecting any rate hikes before November, but the Fed will probably start removing surplus liquidity from the market in the middle of the year, and from Q begin verbally preparing the market for a tighter monetary policy. We expect bond yields to increase in as the signs of a self-sustaining upswing become more apparent and rate hikes move closer. Further upward pressure on yields will come from massive issuance of Treasuries and the cessation of the Fed s buyback programme. The ECB announced at its March meeting that the monthly and weekly liquidity auctions would continue with full allotment at fixed rates until mid-october. This means the market will be awash with liquidity until then, and hence money market rates will be kept below the refi rate. We expect the ECB will prefer to begin normalising this spread before raising the refi rate, and so we have postponed the first rate hike to Q. That said, we still believe the ECB will tighten faster than the market expects. We expect European yields to rise over the coming year as the economic outlook improves and rate hikes move closer. Moreover, we expect to see heavy issuance of government bonds in Euroland and, finally, higher US yields will also pull European yields up. Yield curves Yield curves in both Euroland and the US have flattened a little over the past month but remain very steep. However, as the economy continues to improve, yields move higher and the fixed income market begins to bring forward expectations of rate hikes from the ECB and the Fed, yield curves will gradually begin to flatten. Country spreads We do not anticipate any noticeable shift in country spreads over the coming months, though European bonds are expected to outperform slightly due to the Fed moving first on rates. Danish yields Following the rate cuts in uary, the official spread between Denmark and the euro area is now bp, which is a record low. However, the krone has again strengthened against the euro, and with the prospect of further currency inflows, we expect that Nationalbanken will deliver up to an additional bp in cuts in the coming weeks, though only the current account and certificate of deposit rates will be affected. CIBOR rates are close to bottom. The bulk of the narrowing in the spread between money market rates is expected to come from higher EURIBOR rates when the ECB starts to roll back its temporary, alternative monetary policy. Ultimately, M EURIBOR rates will again rise above the refi rate When the ECB begins to hike early next year, Nationalbanken will follow suit and money market rates will rise in both Euroland and Denmark. We expect higher long Danish yields in the coming quarters in line with developments in Euroland. Marts

3 New forecasts EUR Refi rate m euribor -yr swap -yr swap -yr swap -yr gov -yr gov -yr gov Spot m m m USD Fed funds m libor -yr swap -yr swap -yr swap -yr gov -yr gov -yr gov Spot m m m DKK Repo rate m cibor -yr swap -yr swap -yr swap -yr gov -yr gov -yr gov Spot m m m Source: Danske Markets See charts on following pages Marts

4 International interest rates USD swap rates... -year USD swap rate year USD swap rate EUR swap rates year EUR swap rate -year EUR swap rate Slope of swap yield curve, USD Slope of swap yield curve, EUR bp bp bp bp y EUR swap - y EUR swap y USD swap - y USD swap Country spreads Policy rates bp y USD swap rate - y EUR swap rate bp Refi Rate - - y USD swap rate - y EUR swap rate Fed Funds target rate Marts

5 Danish interest rates Y swap rate Y swap rate..... year swap, DKK year swap, DKK Spreads to eurozone Slope of swap yield curve, DKK bp bp Spread -year swap: DKK-EUR Spread -year swap: DKK-EUR 8 9 bp bp -year DKK swap - -year DKK swap M money market rates Policy rates m cibor m euribor Danish Repo rate... Refi rate Marts

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