Yield Outlook Even more blurred outlook for global yields

Investment Research General Market Conditions 15 January 2019 Yield Outlook Even more blurred outlook for global yields Global risk sentiment and global equity markets came under severe pressure in December, and credit spreads widened. The start to 2019 has been better; we have seen an equity recovery and the S&P500 is up 3%. But, importantly, global yields have not recovered and both 10Y US treasury and Bund yields are more or less at the same level as late December. Powell has calmed financial markets The divergence between the bond and equity markets should be seen in light of the new, more soft rhetoric from global central banks and especially the Federal Reserve. Several Fed members including Fed Chairman Powell have indicated that the Fed can afford to be patient and focus on the more blurred global outlook, as inflation pressure in the US economy remains under control. This gives the Fed time to see whether the market turmoil and slower global growth are temporary or not. The Fed has also said that it is more flexible on the balance sheet reduction. The new, more balanced rhetoric from the Fed is important for global risk appetite. It has removed the risk that the Fed was on auto pilot and would continue hiking rates to neutral (3%) or even above neutral regardless of the underlying economy and financial market developments. Hence, financial markets can feel comfortable that the Fed would step back if the global trade war, government shutdown or the weaker growth in China and Europe start to take their toll on the US economy. Our main case is that global growth will improve Importantly, we have as a main case that US growth will remain above potential this year and furthermore we expect a rebound in global growth in Q2. However, we still expect the Fed to take a temporary pause at the March FOMC meeting. As growth improves and financial markets therefore accept a higher yield, our US economist expects the Fed to hike again at the June and December meetings. This would bring the Fed funds rate to 3%, which we see as the peak. Our view is very different from the market pricing. The market sees no further rate hikes this year and sees a high probability that the Fed funds would be cut in 2020. We have a different view on the Fed than the market 3.40 3M USD LIBOR, 3.20 Quick links Eurozone forecasts US forecasts UK forecasts Denmark forecasts Sweden forecasts Norway forecasts Forecasts table Policy rate outlook Country Spot +3m +6m +12m USD 2.50 2.50 2.75 3.00 EUR -0.40-0.40-0.40-0.20 GBP 0.75 0.75 0.75 1.00 DKK -0.65-0.65-0.65-0.45 SEK -0.25-0.25-0.25-0.25 NOK 0.75 1.00 1.00 1.25 10-year government bond yield outlook Country Spot +3m +6m +12m USD 2.69 2.80 3.10 3.15 GER 0.21 0.40 0.50 0.70 GBP 1.27 1.60 1.90 2.10 DKK 0.13 0.45 0.55 0.75 SEK 0.40 0.80 0.90 1.00 NOK 1.77 2.00 2.20 2.45 Note: EUR = Germany 3.00 2.80 2.60 2.40 2.20 2.00 Chief Analyst Arne Lohmann Rasmussen +45 4512 8532 arr@danskebank.dk Important disclosures and certifications are contained from page 12 of this report. www.danskeresearch.com

Weak activity data and indicators from the Euro zone In respect of the Euro zone, both hard and soft data paint a lacklustre picture of economic activity at the moment. Despite lingering growth headwinds near term, we still expect growth in 2019 to remain robust at 1.5% as continued employment gains and strong real wage growth should support private consumption. The ECB continues to focus on building wage pressures, and we still expect core inflation to rise gradually from Q2 19 onwards, but uncertainty persists on the timing and degree of pass-through from higher wages to core inflation. Wage growth is picking up, which is important for the ECB But economic indicators are worsening for the Euro zone Source: Macrobond Financial Source: Macrobond Financial Given the ECB s focus on wage growth, our Euro zone economists still forecast the first ECB hike of 20bp in December 2019. Similar to the Fed forecast, this is quite different from the market, which only sees a small chance of a 20bp hike in 2019. Our ECB forecast deviates from market pricing 0.40 0.30 0.20 0.10-0.10-0.20-0.30-0.40 3M EURIBOR, % Yield outlook has become even more blurred We forecast German 10Y yields to rise to 0.7% on a 12M horizon. If we are wrong on our ECB call, we will also likely be wrong on our yield forecast. There is a close correlation between European money market rates and longer-dated yields. The chart on the right below shows the 1Y EUR swap 1Y forward and the 10Y EUR swap rate. Hence, the ECB outlook and pricing is pivotal for the long-end. In other words, before we see a re-pricing of central bank expectations we should not expect any major move higher in longer-dated yields. 2 15 January 2019 www.danskeresearch.com

We still hold to the view that 10Y bund and Treasury yields will slowly climb higher during 2019, but mainly on a six- to 12-month horizon as central bank expectations in the market change. However, the outlook has become even more blurred than at our last Yield Outlook in November 2018, when we already stressed the uncertainty. The pricing of ECB is very important for the long-end of the EUR swap curve 0.2 SWAP 1Y 1Y EUR3M SWAP 10Y EUR6M (RHS) 0.1 1.4 1.2 We also stress that for the next couple of months the current weak risk sentiment fuelled by growth concerns, concerns about an escalation of the US-China trade war and softer Fed rhetoric are likely to hold yields around the current level. All in all, we have lowered our 12-month forecast for German 10Y yields to 0.70% from 0.9% earlier. We have also lowered our target for 10Y US treasury yields to 3.15% from 3.50% previously. The tightening is over in Sweden, but would continue in Norway In Sweden, in December the Riksbank delivered the first rate hike since 2011. However, inflation is likely to undershoot the Riksbank forecast once again in 2019: the international growth environment is weaker and the slowing housing market is likely to weigh on growth. We believe the December rate hike by the Riksbank will be its only one for the foreseeable future and we do not expect any more rate hikes this year. In Norway, Norges Bank hiked the target rate by 25bp to 0.75% on 20 September 2018. Norges Bank signalled in December that the next hike should be expected in March 2019, and we see no reason why this hike will not be delivered on time. One more rate hike is likely in 2019. In Denmark, there have been discussions over whether an independent Danish rate hike could be imminent, as the EUR/DKK has been trading above central parity and the central bank intervened in the market in December to support the Danish krone. However, we see this intervention as temporary, related to the sudden drop in equity prices in December, and we expect the Danish central bank to shadow the ECB in 2019. Hence, we do not expect an independent Danish rate hike in 2019. 0-0.1-0.2-0.3-0.4-0.5 1 0.8 0.6 0.4 0.2 0 We plan to publish the next issue of Yield Outlook in mid-february 2019. 3 15 January 2019 www.danskeresearch.com

Eurozone forecasts Both hard and soft data currently still paint a lacklustre picture of economic activity in the euro area. Despite lingering growth headwinds near term, we still expect growth in 2019 to remain robust at 1.5% as continued employment gains and strong real wage growth support private consumption. We expect core inflation to rise gradually from Q2 19 onwards, but uncertainty persists over the timing and degree of pass-through from higher wages to core inflation. We still expect the first ECB hike of 20bp to come only in December 2019. We still expect a steeper EUR yield curve on a 12M horizon. The ECB maintains a tight grip on the short end of the curve. However, this is not the case to the same degree for the 10Y segment of the curve, which we expect to be pushed higher by rising US yields, the end of ECB QE and the pricing of rate hikes in 2019-20. That said, demand for Germany is likely to remain strong and net supply from triple A countries such as Germany and the Netherlands is negative in 2019. Overall, we forecast that 10Y Germany will rise to 0.7 (0.9% previously) on a 12M horizon. If the global trade dispute evolves further or growth weakness becomes more pronounced, it could weigh on the European economy and risk sentiment and keep yields low for longer. EUR forecasts summary Bank forecast and forwards 14/01/2019 --- Forecast --- --- Fcst vs Fwd in bp --- EUR Spot +3m +6m +12m +3m +6m +12m Money Market Refi - - - Deposit -0.40-0.40-0.40-0.20 - - - 3M -0.31-0.33-0.33-0.20-3 -4 3 6M -0.24-0.26-0.26-0.02-4 -5 12 0.40 0.30 0.20 0.10 3M EURIBOR, % Government Bonds 2-year -0.59-0.50-0.40-0.30 - - - 5-year -0.36-0.20 0.10 - - - 10-year 0.22 0.40 0.50 0.70 - - - -0.10-0.20-0.30 Swap rates 2-year -0.16-0.05 0.05 0.15 7 13 12-0.40 5-year 0.19 0.35 0.55 0.65 10 4 22 10-year 0.79 0.90 1.00 1.20 6 10 20 3M Euribor 10Y EUR swap rates 4 15 January 2019 www.danskeresearch.com

US forecasts Several FOMC members including the most important ones have indicated that while the base case remains further gradual rate hikes, the Fed can afford to be patient at the beginning of the year, as inflation pressure remains under control. This gives the Fed time to see whether the market turmoil and slower global growth are temporary or not. The Fed has also let the genie out the bottle by saying that it is also more flexible on the balance sheet reduction. As we believe US growth will remain above potential this year and as we expect a rebound in global growth in Q2, we also expect the Fed will continue hiking. Our base case is hikes in June and December, which would be the last hikes in this cycle. The timing is more difficult this year, as every meeting could be live, as chair Powell will host a press conference after every meeting starting from the January meeting. We still see a case for higher 2Y yields, as we continue to expect hikes, contrary to market pricing. In respect of the long end,we assume an effect on the yield level from the more expansive US fiscal policy, which has boosted US bond supply. The move in USD FX forwards has made FX hedging of USD assets very expensive and it is more attractive to buy EUR- or even JPY-denominated bonds than US bonds despite the higher yield level. Hence, we now expect 10Y US treasury yields to reach 3.15% on a 12M horizon (3.50% previously). USD forecasts summary Bank forecast and forwards 14/01/2019 --- Forecast --- --- Fcst vs Fwd in bp --- USD Spot +3m +6m +12m +3m +6m +12m Money Market Fed Funds 2.50 2.50 2.75 3.00 - - - 3M 2.79 2.92 2.97 3.23 20 22 57 3.50 3.00 2.50 3M USD LIBOR, Government Bonds 2-year 2.51 2.70 3.00 3.10 - - - 5-year 2.49 2.70 3.10 3.10 - - - 2.00 1.50 10-year 2.67 2.80 3.10 3.15 - - - Swap rates 2-year 2.67 2.85 3.15 3.25 22 55 72 1.00 0.50 5-year 2.58 2.80 3.20 3.20 23 63 64 10-year 2.70 2.85 3.15 3.20 15 45 48 3M USD Libor rates 10Y USD swap rates 5 15 January 2019 www.danskeresearch.com

UK forecasts In the very short run, we have the Brexit vote in the House of Commons today, Tuesday 15 January, which PM Theresa May is widely expected to lose. The question is what then? We are in uncharted territory and it is difficult to predict the final outcome. That said, we argue that a decent Brexit (PM Theresa May s deal or something similar) or a second EU referendum are the two most likely outcomes right now. We are having a hard time seeing a soft Norway-style Brexit or snap election. No deal Brexit is the default option but the recent development shows that there is a majority in the Commons against that outcome. The problem is that no credible alternative with backing from a majority in the Commons has emerged yet. We need to see how things settle in the coming weeks. Due to a combination of market turmoil, slower global growth, and disappointing UK data, we have changed our Bank of England call and now expect the next bank rate hike to arrive in November (previously May), but our forecast among other things depends on the Brexit outcome. The UK money market curve is relatively flat, with the next hike priced to arrive in spring 2020. While this is slightly dovish compared to our expectations, we think market pricing is fair for now especially given the uncertainty related to Brexit. Over the medium term, we generally forecast higher yields across the curve driven by a further BoE rate hike and higher global yields. UK forecasts summary Bank forecast and forwards 14/01/2019 --- Forecast --- --- Fcst vs Fwd in bp --- GBP Spot +3m +6m +12m +3m +6m +12m Money Market Repo 0.75 0.75 0.75 1 - - - 1.80 1.50 6M LIBOR, % 3M 0.92 0.87 1.07 1.08-8 5-4 Government Bonds 2-year 0.79 1.00 1.10 1.30 18 27 45 1.20 0.90 5-year 0.933 1.35 1.45 1.7 36 44 65 10-year 1.27 1.60 1.90 2.10 26 53 66 0.60 Swap rates 2-year 1.16 1.30 1.40 1.60 10 16 30 0.30 5-year 1.31 1.65 1.75 2.00 32 40 48 10-year 1.45 1.70 2.00 2.20 23 51 68 3M GBP Libor rates 10Y UK swap rates 6 15 January 2019 www.danskeresearch.com

Denmark forecasts In December, Nationalbanken sold foreign currency amounting to DKK12bn to support the krone. This triggered market talk that an independent Danish rate hike could be imminent to support the krone. However, we hold the view that the intervention was due to temporary DKK negative flows related to Danish investors rebalancing their FX hedges on foreign portfolios, as global equity markets dropped markedly in December. It did not reflect an underlying DKK selling pressure and intervention should be more than enough to stabilise the EUR/DKK exchange rate, in our view. All in all, we still expect Danmarks Nationalbank to shadow the ECB in 2019, i.e. raise the certificates of deposit rate by 20bp in December 2019. The 2019 budget showed the Ministry of Finance plans to buy back more than DKK50bn worth of the new government-guaranteed mortgage bonds that are set to finance social housing. This is to be funded by a major drawdown on the government account in 2019, rather than increasing the supply of government bonds. Hence, a substantial volume of liquid funds is likely to enter the Danish market, which would push Danish yields lower in 2019. On the other hand, the government bonds will not see support from buybacks, which was the case in 2018. DKK forecasts summary Bank forecast and forwards DKK Spot +3m --- Forecast --- --- Fcst vs Fwd in bp --- 0.70 6M CIBOR, % +6m +12m +3m +6m +12m Money Market 0.60 CD -0.65-0.65-0.65-0.45 - - - 0.50 Repo 0.05 0.05 0.05 0.05 - - - 0.40 3M -0.29-0.30-0.30-0.03-4 -7 15 0.30 6M -0.14-0.15-0.12 0.19-5 -5 21 0.20 Government bonds 0.10 2-year -0.58-0.50-0.40-0.30 - - - 5-year -0.30-0.15 0.05 0.15 - - - 10-year 0.13 0.45 0.55 0.75 - - - -0.10 Swap rates -0.20 2-year -0.04 0.05 0.15 0.25 5 11 11 5-year 0.31 0.45 0.65 0.75 8 22 19 10-year 0.92 1.05 1.15 1.35 8 13 23 3M Cibor rate 10Y DKK swap rates 7 15 January 2019 www.danskeresearch.com

Sweden forecasts Despite revising GDP estimates, in December the Riksbank hiked the repo rate for the first time since 2011. Simultaneously, the RB delayed the next (projected) rate increase from summer to autumn. In addition, minutes from the December policy meeting show that the RB is far from being on a pre-set course. Intensifying uncertainty and downside risks regarding the growth outlook played an important part in the discussion. This is obviously a concern the Riksbank shares with many other central banks. In fact, we see a somewhat higher than 50% probability that the Riksbank will push a second hike further down the road and our main view is that we not see any rate hikes from the Riksbank in 2019. The SEK money market curve does not currently price in another full 25bp rate hike until the beginning of 2020. From 2020 and over the next four to five years, implied rate hikes in Sweden are almost identical to what is priced on the ECB - about one 25bp rate hike per year. We see no particular reason that would motivate SEK pricing to drop below that of the EUR. On the other hand, we expect yields out to five years to be quite reluctant to move higher too, as long as growth is moderating. However, a factor to consider is the US, where we feel the market has been too quick to price in a recession premium (i.e. rate cuts from the Fed). If we are correct, we are likely to see some correction in US rates, which we expect to affect primarily the longer end of the Swedish curve, translating into a steeper yield curve. SEK forecasts summary Bank forecast and forwards --- Forecast --- --- Fcst vs Fwd in bp --- SEK Spot +3m +6m +12m +3m +6m +12m Money market Repo -0.25-0.25-0.25-0.25 - - - 3M -0.08-0.20-0.20-0.20-10 -14-27 Government bonds 2-year -0.38-0.35-0.40-0.40 - - - 5-year -0.06 0.05 0.10 0.10 - - - 10-year 0.40 0.80 0.90 1.00 - - - Swap rates 2-year 0.06 0.05-6 -18-31 5-year 0.46 0.55 0.55 0.55 3-4 -18 10-year 1.06 1.25 1.30 1.40 14 14 13 0.50 0.40 0.30 0.20 0.10-0.10-0.20-0.30 3M STIBOR, % 3M Stibor rate 10Y SEK swap rates 8 15 January 2019 www.danskeresearch.com

Norway forecasts Norges Bank has signalled that the next hike should be expected in March 2019. The Monetary Policy Report 3/18 s new rate path indicates slightly fewer than two hikes per year in 2019-21. At present, the market is below Norges Bank s money market projection for 2019 and 2020. The Norwegian output gap seems to be closed and a pick-up in oil investments going forward suggests above-trend growth in 2019. Activity in Q3 last year was somewhat disappointing. Q3 mainland GDP at 0.3% q/q was below Norges Bank s projection of 0.7%. However, the weakness appears to be temporary and the monthly GDP projections from Statistics Norway point to a clear pick-up in activity in Q4. The Norwegian PMI also came in higher in December despite the negative news from the global economy. We expect 5Y and 10Y yields to widen further versus peers in 2018-19, as the Norwegian economy is improving and as Norges Bank hikes rates before the ECB. NOK forecasts summary Bank forecast and forwards --- Forecast --- --- Fcst vs Fwd in bp --- NOK Spot +3m +6m +12m +3m +6m +12m Money market Deposit 0.75 1.00 1.00 1.25 - - - 2.50 2.00 6M NIBOR, % 3M 1.26 1.40 1.52 1.71 9 15 25 6M 1.40 1.58 1.67 1.87 15 19 31 1.50 Government bonds 2-year 0.80 1.10 1.25 1.50 - - - 1.00 5-year 1.33 1.85 2.00 2.20 - - - 10-year 1.77 2.00 2.20 2.45 - - - Swap rates 0.50 2-year 1.54 1.80 1.95 2.20 22 32 47 5-year 1.80 2.30 2.45 2.65 46 57 69 10-year 2.10 2.35 2.55 2.80 22 39 58 3M Nibor rate 10Y NOK swap rates 9 15 January 2019 www.danskeresearch.com

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 2.50 2.79 2.69 2.60 2.71 2.52 2.51 2.69 +3m 2.50 2.92 2.85 2.80 2.85 2.70 2.70 2.80 +6m 2.75 2.97 3.15 3.20 3.15 3.00 3.10 3.10 +12m 3.00 3.23 3.25 3.20 3.20 3.10 3.10 3.15 Spot -0.40-0.31-0.17 0.17 0.77-0.60-0.38 0.21 +3m -0.40-0.33-0.05 0.35 0.90-0.50-0.20 0.40 +6m -0.40-0.33 0.05 0.55 1.00-0.40 0.50 +12m -0.20-0.06 0.15 0.65 1.20-0.30 0.10 0.70 Spot 0.75 0.92 1.16 1.31 1.45 0.79 0.93 1.27 +3m 0.75 0.87 1.30 1.65 1.70 1.00 1.35 1.60 +6m 0.75 1.07 1.40 1.75 2.00 1.10 1.45 1.90 +12m 1.00 1.08 1.60 2.00 2.20 1.30 1.70 2.10 Spot -0.65-0.29-0.04 0.31 0.92-0.58-0.30 0.13 +3m -0.65-0.30 0.05 0.45 1.05-0.50-0.15 0.45 +6m -0.65-0.30 0.15 0.65 1.15-0.40 0.05 0.55 +12m -0.45-0.03 0.25 0.75 1.35-0.30 0.15 0.75 Spot -0.25-0.08 0.06 0.46 1.06-0.38-0.06 0.40 +3m -0.25-0.20 0.05 0.55 1.25-0.35 0.05 0.80 +6m -0.25-0.20 0.55 1.30-0.40 0.10 0.90 +12m -0.25-0.20 0.55 1.40-0.40 0.10 1.00 Spot 0.75 1.40 1.54 1.80 2.10 0.80 1.33 1.77 +3m 1.00 1.58 1.80 2.30 2.35 1.10 1.85 2.00 +6m 1.00 1.67 1.95 2.45 2.55 1.25 2.00 2.20 +12m 1.25 1.87 2.20 2.65 2.80 1.50 2.20 2.45 * German government bonds are used, EUR swap rates are used 10 15 January 2019 www.danskeresearch.com

Contents and contributors Eurozone... 4 Macro Senior Analyst Aila Mihr +45 45 12 85 35 amih@danskebank.dk Interest rates Chief Analyst Arne Lohmann Rasmussen +45 45 12 85 32 arr@danskebank.dk US... 5 Macro & interest rates Senior Analyst Mikael Olai Milhøj +45 45 12 76 07 milh@danskebank.dk Interest rates Chief Analyst Arne Lohmann Rasmussen +45 45 12 85 32 arr@danskebank.dk UK... 6 Macro & interest rates Senior Analyst Morten Helt +45 45 12 85 18 mohel@danskebank.dk Denmark... 7 Macro Chief Economist Las Olsen +45 45 12 85 36 laso@danskebank.dk Interest rates Chief Analyst Arne Lohmann Rasmussen +45 45 12 85 32 arr@danskebank.dk Sweden... 8 Macro & interest rates Chief Analyst Michael Boström +46 8 568 80587 mbos@danskebank.com Senior Analyst Michael Grahn +46 8 568 80700 mika@danskebank.com Senior Analyst Marcus Söderberg +46 8 568 80564 marsd@danskebank.com Senior Analyst Carl Milton +46 8 568 80598 carmi@danskebank.com Norway... 9 Macro & interest rates Chief Analyst Jostein Tvedt +47 23 13 91 84 jtv@danskebank.dk Forecasts table... 10 11 15 January 2019 www.danskeresearch.com

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