Yield Outlook Risk to 10Y yields is now more two sided

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1 Investment Research General Market Conditions 16 November 2017 Yield Outlook Risk to 10Y yields is now more two sided In past editions of Yield Outlook, we have argued that bond yields (represented by 10Y US Treasuries and German Bunds) are likely to range trade throughout This is still our view and we think the range trading will extend into Q1 18. However, recently, we have seen slightly higher volatility than usual. At the beginning of November, we saw a surprise move higher in both US and German yields. It is unclear to us what triggered this move but falling yields even after the ECB decision to scale down bond purchases in 2018 might have triggered some profit taking from investors positioned for lower yields and carry, especially as we started to see more hawkish comments from a number of ECB members that the ECB could leave its gradualist approach. However, the move higher in yields lasted only a few days and we have seen an almost 180 degree turn in sentiment. This time the trigger was weak sentiment in the global equity market, which has pushed investors into the safe global bond markets. Hence, German 10Y yields are back at the level seen in September. Downward pressure on global yields Quick links Eurozone forecasts US forecasts UK forecasts Denmark forecasts Sweden forecasts Norway forecasts Forecasts Policy rate outlook Country Spot +3m +6m +12m USD EUR GBP DKK SEK NOK year government bond yield outlook The move lower in yields this week underlines that despite the ECB scaling back on bond purchases, a strong global business and Fed rate hikes we should not expect to see a rapid further rise in either US or European long yields (10Y). The overall inflationary pressure is still low and the zero-rate policy in Japan and continued QE bond purchases (though lower) in Europe are keeping a lid on long yields in both Europe and the US. Furthermore, if the negative sentiment continues in the global equity market, we could see a sector rotation into bonds. This week Bloomberg reported that the largest US Pension fund Calpers is looking to double its bond allocation to reduce the risk and volatility in its portfolio. Country Spot +3m +6m +12m USD GER GBP DKK SEK NOK Note: EUR = Germany Chief Analyst Arne Lohmann Rasmussen arr@danskebank.com Important disclosures and certifications are contained from page 12 of this report.

2 Risks to 10Y yields in both Europe and the US have become more two sided We have previously argued that the risk to rates was asymmetric on the upside given global central banks normalisation policies. However, the latest move lower in yields on the back of the setback in global risk appetite also underlines that the downside to yields, especially in the US, should not be understated. If investors rotate more heavily into the global bond market, the high yielding US bond market stands out. Overall, we now argue that the outlook for yields over the next couple of months has now become more symmetric and that the downside potential for yields should not be neglected. Market still priced too soft in US flatter 2Y10Y curve in USD We still think markets are pricing in too few hikes in the US next year (only one additional hike on top of the widely expected December 2017 hike). If our baseline scenario is correct, it should push US yields slightly higher in We maintain our 12M forecast of 2.70% for 10Y US Treasury yields. We continue to expect a flattening of the US curve for the 2Y10Y on a 12M horizon. We believe the short end could be pushed higher by Fed rate hikes, while the long end could be kept low by investors buying high yielding US fixed income assets. Modest steepening of the 2Y10Y curve in Germany is our main case In Germany, we expect a modestly steeper yield curve for the 2Y10Y in We expect the ECB to maintain a tight grip on the short end of the curve in However, this is not the case for the 10Y segment of the curve, which we expect to be pushed by higher US yields and a smaller QE programme. We have a 12M 0.75% forecast for 10Y Germany. However, we may be underestimating the downward pressure on 10Y yields in Germany from the continued ECB purchases, which now include a growing amount of reinvestment from bonds maturing. The healthy German economy also implies that the funding need and henceforth bond issuance for Germany will be modest in November

3 Contents and contributors Eurozone...4 Macro Senior Analyst Aila Mihr Interest rates Chief Analyst Arne Lohmann Rasmussen US...5 Macro & interest rates Senior Analyst Mikael Olai Milhøj Interest rates Chief Analyst Arne Lohmann Rasmussen UK...6 Macro & interest rates Senior Analyst Morten Helt Denmark...7 Macro Chief Economist Las Olsen Interest rates Chief Analyst Arne Lohmann Rasmussen Sweden...8 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...9 Macro & interest rates Chief Analyst Jostein Tvedt Forecasts November

4 Eurozone forecasts Economic data in the eurozone continues to point to an ongoing recovery in 2017 and 2018, with strong PMIs and high consumer optimism across countries. However, recent data releases also highlight the ECB s current dilemma: while GDP accelerated by more than expected in Q3 (2.5% y/y), inflation continues to disappoint on the downside, with the headline figure falling from 1.5% in September to 1.4% in October. Since it started to scale down its 2018 QE purchases at the October meeting, the decline in core inflation to 0.9% is particularly unwelcome news for the ECB, which still hopes that a combination of employment gains and closing output gap will drive up underlying price pressure eventually. Although we think the ECB is too optimistic in its core inflation forecast, we still expect the ECB gradually to move ahead with its cautious scaling back of monetary stimulus in 2018, as long as core inflation recovers to above 1.0% and the economic recovery continues. We continue to expect a modestly steeper EUR yield curve for the 2Y10Y in The ECB maintains a tight grip on the short end of the curve. However, this is not the case for the 10Y segment of the curve, which we expect to be pushed by higher US yields and a smaller QE programme. We have a 12M 0.75% forecast for 10Y Germany. EUR forecasts summary 15/11/ Forecast Fcst vs Fwd in bp --- EUR Spot +3m +6m +12m +3m +6m +12m Money market Refi Deposit M Government bonds 2-year year year Swap rates 2-year year year EUR swap curve one-month change 2.0 % bp Change,bp (rhs) 16-Oct Nov-17 3M Euribor 10Y EUR swap rates, Macrobond Financial, Macrobond Financial 4 16 November

5 US forecasts The Fed has announced that it has begun the process of shrinking the balance sheet ( quantitative tightening ), while still signalling another Fed hike this year, likely to be in December. It remains our base case that the Fed will hike in December, as the core voting FOMC members put more weight on labour market data than on current inflation data. Jerome H. Powell has now been nominated to succeed Janet Yellen as Fed Chair. Powell is considered to be in the same neutral rate camp as Yellen. Hence, we believe he will vote for two rates hikes in 2018 if the economy evolves as expected. The markets now price in a relatively high probability of a December hike of 90%, which seems much fairer, in our view, than a few months ago when the market priced in a small probability of a hike. However, we still think markets are pricing in too few hikes next year (only one additional hike). If our baseline scenario is correct, it should push US yields slightly higher. However, we do not see a major sell-off this year. We continue to expect a flattening of the curve for the 2Y10Y on a 12M horizon. We believe the short end could be pushed higher by Fed rate hikes, while the long end could be kept low by investors buying high yielding US fixed income assets. USD forecasts summary 15/11/ 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) 16-Oct Nov-17 3M USD Libor rates 10Y USD swap rates, Macrobond Financial, Macrobond Financial 5 16 November

6 UK forecasts As expected, the Bank of England (BoE) raised the Bank Rate by 25bp to 0.50% from 0.25%, with a vote count of 7-2, at the November MPC meeting. It was a dovish hike in the sense that the MPC refrained from commenting on future rate hikes. CPI inflation was unchanged at 3.0% y/y in October. The increase in inflation should be temporary as much is due to the past weakening of the GBP. Moreover, wage growth remains subdued and while the unemployment rate fell to 2.2% in September (down from an upward revised 2.3% in August), there are signs the labour market may be slowing as the number of employed people fell (for the first time in almost a year). Hence, data still support our view that BoE will stay on hold in 2018 and not hike again before With a second rate hike priced in by November 2018 and the third in Q4 20, we see market pricing as slightly on the hawkish side pointing to some downside risk in the 0-2Y segment in coming months. Further out on the yield curve, we look for yields to trade around current levels in coming months. On a 6-12M horizon, we expect the 2Y10Y yield curve to steepen moderately, with the long end of the curve being driven by higher yields in the US and Europe. UK forecasts summary 15/11/ 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) 16-Oct Nov-17 3M GBP Libor rates 10Y UK swap rates, Macrobond Financial, Macrobond Financial 6 16 November

7 Denmark forecasts We do not expect rate changes from the Danish central bank over the next 12 months. If anything, we could see the central bank intervening in the market to weaken the Danish krone, as fundamentals such as the significant current account surplus are still tending to strengthen the DKK. The 3M Cibor-Euribor has tightened this year. High liquidity in the money market is dragging Cita rates lower and Cibor fixings down. We expect DKK fixings to remain at the current level or fall to a slightly lower level for the time being. We have this year seen that DKK swap rates continued to tighten versus EUR swap rates 10Y and 5Y5Y spreads in particular have tightened. We could see a continuation of this overall trend but we are probably approaching levels where we should not expect any significant tightening. Danish government bonds have also tightened versus those of Germany this year. We expect the Debt Management Office to continue conducting switches to support liquidity, particularly in 2Y and 10Y bonds. We expect supply in 2018 to be unchanged at DKK65bn, according to the new budget. Some of the issuance will now fund social housing. Our base scenario expects the bond yield spread to Germany to remain at more or less the current level. DKK forecasts summary 15/11/ 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) 16-Oct Nov-17 3M Cibor rate 10Y DKK swap rates, Macrobond Financial, Macrobond Financial 7 16 November

8 Sweden forecasts As year-end nears, we are approaching the Riksbank decision on whether to continue purchasing bonds. Our guess is that the QE programme will end but acknowledge that it is a close call. In any case, the minutes from the Riksbank s October meeting reveal that three (out of six) members leaned towards ending. In the meantime, a few weeks ago the Debt Office published a new forecast showing a considerably smaller borrowing requirement for the coming two years than previously expected. Consequently, bond issuance is scaled back, which partially dampens the potential for higher long-term rates resulting from a decision by the Riksbank to stop buying bonds. In particular, the stock of bills is slashed to an all-time low, implying a looming shortage of short material probably indirectly also affecting short-term swaps However, the potentially most crucial issue right now is intensified signs of the housing market cooling off fast. So far, evidence is mostly of anecdotal nature. The underlying factor is the significant supply of new (mostly rather expensive) flats in recent years, supply that will continue to grow for some time considering the projects already begun. Rates (unlike the Swedish krona) have not yet responded much but, in the case of a more negative development, the outlook for monetary policy could change making future rate hikes more uncertain. SEK forecasts summary 15/11/ 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) 16-Oct Nov M Stibor rate 10Y SEK swap rates, Macrobond Financial, Macrobond Financial 8 16 November

9 Norway forecasts Norges Bank s market guidance at the 25 October policy meeting was basically the same as outlined in the 21 September Monetary Policy Report 3/17. Norges Bank indicates a first hike in the target rate towards mid As we expect somewhat stronger growth and higher wage growth, we expect the first rate hike at the end of Recent data confirm the recovery case for the Norwegian economy. Q3 mainland GDP grew 0.6% q/q, i.e. in line with growth in the first half of the year. Growth is broad based. Consumer confidence is strong. The upward trend in Norwegian PMI still seems intact, despite substantial volatility in the index. Mortgage market regulations, introduced at the start of the year, seem to be cooling the housing market particularly in the Oslo area. We do not expect the recent slowdown in the housing market to have any significant effect on monetary policy, as so far it is in line with Norges Bank s expectations. We expect 5Y and 10Y yields to be stable versus peers in 2017, as the Norwegian economy is improving slowly. However, on a 12M horizon, we could see a modest widening towards peers. NOK forecasts summary 15/11/ 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 2.7 % bp Change,bp (rhs) 16-Oct Nov-17 3M Nibor rate 10Y NOK swap rates, Macrobond Financial, Macrobond Financial 9 16 November

10 Forecasts Forecasts USD EUR * GBP NOK SEK DKK 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 November

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