Yield Outlook Range trading in 2017, but risk is skewed to the upside

Investment Research General Market Conditions 19 June 2017 Yield Outlook Range trading in 2017, but risk is skewed to the upside We continue to see further upside for 10Y German Bund yields on a 12-month horizon but we expect no major changes in 2017. This is also the case for Swedish, Danish and Norwegian yields. Range trading for the rest of 2017 is our call. In general, we do not expect the market to price in an ECB tapering premium before 2018, as continued low inflation and a slightly less strong growth outlook have removed the need for tighter ECB monetary policy for now. We also expect the ECB to prolong its purchase programme into 2018. We do not think too much weight should be put onto the ECB having removed the probability of a new rate cut. We believe it will keep negative policy rates for some time as inflationary pressure remains muted given that wage growth is not expected to pick up. In the US market, the Fed came out slightly on the hawkish side when it hiked the Fed Funds rate by 25bp to 1.25%, despite recent low inflation prints. It seems that the Fed is focused primarily on the labour market and unemployment rate and less on actual inflation. Therefore, we still believe the Fed will hike one more time this year. We expect two hikes next year but think risks are skewed towards the Fed pausing its hiking cycle. Note that the Fed still has three hikes in its own dots. It means that the upside risk to the 10Y segment of both the US and the European curves in 2018 is now smaller than we thought previously. All in all, we expect the 10Y Bund yield to rise to 0.75% (previously 0.90%) and the 10Y US Treasury yield to 2.70% (3.0%) on a 12-month horizon. Asymmetric risk to yields, but range trading for 2017 is our call Despite the continued recovery in especially eurozone growth and the risk of both the ECB and the Fed coming out more hawkish later in the year or early 2018, we stick to our view that 10Y bond yields in Germany, Scandinavia and the US will remain in a close range around the current level for the rest of 2017. However, in 2018, the picture is changing. The ECB will have started tapering and the Fed will be on course to deliver further rates hikes, and very little is priced into the US curve. We might also have read the ECB wrongly. The ECB might test the market to see if a more hawkish stance is prudent and possible. The same goes for the Fed, which seems somewhat more hawkish than is priced into the market. We might also underestimate the impact of a possible Fed decision to change its reinvestment policy. We might also be wrong on the economic outlook and put too much weight on the apparent peak in economic indicators. The momentum in eurozone growth might be underestimated. The same goes for inflation in the eurozone. We forecast that inflation and not least core inflation will peak here in Q2 based on the view that wage growth will stay low. If we are wrong in these assumptions, we could also be wrong in the assumption that yields will not rise before 2018. 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 1.25 1.25 1.50 1.75 EUR -0.40-0.40-0.40-0.40 GBP 0.25 0.25 0.25 0.25 DKK -0.65-0.65-0.65-0.65 SEK -0.50-0.50-0.50-0.50 NOK 0.50 0.50 0.50 0.50 10-year swap rate outlook Country Spot +3m +6m +12m USD 2.15 2.25 2.35 2.70 EUR 0.77 0.85 0.90 1.15 GBP 1.11 1.25 1.35 1.75 DKK 1.01 1.10 1.15 1.40 SEK 1.05 1.10 1.30 1.50 NOK 1.89 1.95 2.00 2.30 Chief Analyst Arne Lohmann Rasmussen +45 45 12 85 32 arr@danskebank.dk Assistant Analyst Nina T. B. Andersen +45 45 12 82 87 nian@danskebank.dk Important disclosures and certifications are contained from page 10 of this report. www.danskeresearch.com

Contents and contributors Eurozone...3 Macro Senior Analyst Pernille B. Henneberg +45 45 13 20 21 perni@danskebank.dk Interest rates Chief Analyst Arne Lohmann Rasmussen +45 45 12 85 32 arr@danskebank.dk US...4 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...5 Macro & interest rates Senior Analyst Morten Helt +45 45 12 85 18 mohel@danskebank.dk Denmark...6 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...7 Macro & interest rates Chief Analyst Michael Boström +46 (0)8-568 805 87 mbos@danskebank.com Senior Analyst Michael Grahn +46 (0)8-568 807 00 mika@danskebank.com Senior Analyst Marcus Söderberg +46 (0)8-568 805 64 marsd@danskebank.com Senior Analyst Carl Milton +46 (0)8-568 805 98 carmi@danskebank.com Norway...8 Macro & interest rates Chief Analyst Jostein Tvedt +47 23 13 91 84 jtv@danskebank.dk Forecasts table...9 2 19 June 2017 www.danskeresearch.com

Eurozone forecasts The ECB changed its forward guidance on policy rates at the meeting in early June and no longer expects these to go to lower levels. The rest of the forward guidance was left unchanged implying the ECB now expects policy rates to remain at their present levels for an extended period of time, and well past the horizon of the net asset purchases. Regarding the QE purchases, the ECB still has an easing bias as it communicated that it stands ready to increase QE in terms of size and/or duration. We still believe the ECB will announce an extension of its QE programme in September but continue its purchases at a slower pace of EUR40bn per month going into 2018. The continued QE purchases should follow as the underlying price pressure remains too weak for the ECB to withdraw its very accommodative monetary accommodation. We continue to expect a steeper EUR yield curve for the 2Y10Y in 2018. The ECB still has a tight grip on the short-end of the curve, especially as it is now buying below the depo rate at -0.4%. However, 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 2018. This is mainly a theme on a 12M horizon. Note that we have revised our 12M forecast for 10Y German yields lower from previously 0.90% to 0.75%. EUR forecasts summary EUR Spot +3m +6m +12m +3m +6m +12m Refi 0.00 0.00 0.00 0.00 - - - Deposit -0.40-0.40-0.40-0.40 - - - 3M -0.33-0.35-0.35-0.35-3 -4-9 2-year -0.63-0.65-0.60-0.50 - - - 5-year -0.37-0.35-0.30-0.20 - - - 10-year 0.31 0.40 0.45 0.75 - - - 2-year -0.18-0.10-0.05 0.00 +4 +5-5-year 0.15 0.20 0.25 0.30-1 -9 10-year 0.77 0.85 0.90 1.15 +2 +2 +16 EUR swap curve One month change 2.0 % bp 0 1.5 1.0-4 0.5-6 0.0-8 -0.5-10 Change,bp (rhs) 16-May-17 16-Jun-17 3M Euribor 10Y EUR swap rates 3 19 June 2017 www.danskeresearch.com

US forecasts As very much expected by everyone but us, the Federal Reserve hiked its target range by 25bp to 1.00-1.25% at its June meeting. We are not surprised given the very high expectations but we were surprised the Fed was not more concerned about low inflation. We did not think economic data supported a hike. For more see also FOMC Review: Hawkish Yellen ignores inflation and weaker data, 15 June. Given that the Fed more or less just targets the unemployment rate, we are still inclined to believe the Fed will hike one more time this year. We also expect more details about when the Fed will begin quantitative tightening at the next big meeting in September, as the Fed seems very eager to begin shrinking the balance sheet. We expect two hikes next year but think risks are skewed towards the Fed pausing its hiking cycle. As we now expect at least one less Fed hike until year018 and inflation expectations have declined (and they may not rebound due to a more hawkish Fed), we have lowered our 12M forecast for 10yr Treasury yield forecast to 2.7% from 3.0% previously. We expect a slightly flatter US yield curve, as the 2-5yr Treasury yields are expected to rise the most. We think US yields are range-bound for now but will move higher later this year when markets reprice the Fed. USD forecasts summary USD Spot +3m +6m +12m +3m +6m +12m Fed Funds 1.25 1.25 1.50 1.75 - - - 3M 1.25 1.38 1.60 1.90 +3 +17 +30 2-year 1.36 1.40 1.60 2.00 - - - 5-year 1.77 1.90 2.00 2.30 - - - 10-year 2.17 2.30 2.40 2.70 - - - 2-year 1.55 1.70 1.85 2.25 +8 +17 +45 5-year 1.85 2.00 2.10 2.40 +10 +15 +37 10-year 2.15 2.25 2.35 2.70 +6 +13 +42 USD swap curve One month change 3.0 % bp 10 2.5 5 2.0 0 1.5-5 1.0 0.5-10 0.0-15 Change,bp (rhs) 16-May-17 16-Jun-17 3M USD Libor rates 10Y USD swap rates 4 19 June 2017 www.danskeresearch.com

UK forecasts GDP growth slowed in Q1 to 0.2% q/q (the slowest among the EU economies) and economic indicators for Q2 have not been strong either. The combination of higher inflation and low wage growth means real wage growth has turned negative, which has slowed private consumption growth. We expect UK growth to remain weak in coming years due to slower private consumption growth and weak business investments. Bank of England (BoE) again delivered a hawkish surprise to the markets at its June meeting, as three members voted for an immediate hike and the phrase it can move in either direction was removed from the meeting summary. Despite the hawkish wing within the Monetary Policy Committee, we still think the core (including BoE Governor Mark Carney) is quite dovish so we do not expect a BoE hike at least until after the Brexit negotiations are concluded by the end of March 2019. This is in line with current market pricing. For more see Bank of England Review: Hawkish wing but neutral core, 15 June. 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 yield curves to steepen, as we expect the short end of the curve to stay low. UK forecasts summary GBP Spot +3m +6m +12m +3m +6m +12m Repo 0.25 0.25 0.25 0.25 - - - 3M 0.29 0.31 0.31 0.31-4 -8-14 2-year 0.18 0.20 0.20 0.25 +1-1 5-year 0.49 0.60 0.65 0.85 +8 +7 +18 10-year 1.05 1.20 1.30 1.70 +9 +15 +43 2-year 0.53 0.55 0.55 0.55-5 -12 5-year 0.75 0.85 0.90 1.10 +6 +7 +19 10-year 1.11 1.25 1.35 1.75 +11 +18 +51 UK swap curve One month change 1.6 % bp 0 1.4 1.2 1.0-4 0.8-6 0.6-8 0.4 0.2-10 0.0-12 Change,bp (rhs) 16-May-17 16-Jun-17 3M GBP Libor rates 10Y UK swap rates 5 19 June 2017 www.danskeresearch.com

Denmark forecasts We expect no rate changes from the Danish central bank over the next twelve months. If anything, we could see the central bank intervening in the market to weaken the krone, as fundamentals such as the significant current account surplus still tend to strengthen DKK. We have recently seen that the 6M Cibor-Euribor spread has widened, as the move lower in Euribor fixings has not been reflected in a similar move in Cibor 6M fixings. Despite the slightly wider fixing spread, we have seen DKK swap rates continue to tighten versus EUR swap rates 10Y and 5Y5Y spreads have tightened in particular. We could see a continuation of the overall trend this year that DKK rates tighten versus the EUR. Danish government bonds have also tightened marginally versus Germany this year. The Debt Management Office will continue to conduct switches to support liquidity, especially in the new 2Y and 10Y bonds. However, the Debt Office will also conduct outright buybacks funded by the booming government account at the central bank. Our base scenario expects the bond yield spread to Germany and the DKK-EUR swap spread to stay at the current level or slightly tighter. The Debt Management Office may lower the supply of Danish government bonds in 2017, adding support to the Danish bond market. We forecast a steeper curve 2Y10Y in Denmark as in Europe. DKK forecasts summary DKK Spot +3m +6m +12m +3m +6m +12m CD -0.65-0.65-0.65-0.65 - - - Repo 0.05 0.05 0.05 0.05 - - - 3M -0.22-0.20-0.20-0.20 +1-1 -6 6M -0.08-0.05-0.05-0.05 +1-3 -13 2-year -0.55-0.55-0.50-0.40 - - - 5-year -0.24-0.20-0.15-0.05 - - - 10-year 0.56 0.65 0.70 1.00 - - - 2-year 0.02 0.10 0.15 0.20 +4 +5-5-year 0.36 0.40 0.45 0.50-3 -11 10-year 1.01 1.10 1.15 1.40 +3 +3 +17 DKK swap curve One month change 2.0 % bp 2 1.5 0 1.0-4 0.5-6 0.0-8 -0.5-10 Change,bp (rhs) 16-May-17 16-Jun-17 3M Cibor rate 10Y DKK swap rates 6 19 June 2017 www.danskeresearch.com

Sweden forecasts Swedish rates have performed strongly over the past couple of months on the back of a dovish Riksbank and supportive flows and index extensions. The performance at the short end of the curve has defied the pattern over the past year, i.e. moving in tandem with inflation data outcome, as the two last readings were above expectations. However, we could experience some lack of bond supply as issuance take a pause over the summer amid big redemption flows. This could be supportive for short-end bonds and outperformance relative to swaps. The July Riksbank meeting will probably be unexciting. However, later in the year, we expect further downside deviations from the Riksbank's inflation forecasts. Thus, later in the year, the meetings should become more interesting again. SEK forecasts summary SEK Spot +3m +6m +12m +3m +6m +12m Repo -0.50-0.50-0.50-0.50 - - - 3M -0.50-0.48-0.48-0.48-1 +5-17 2-year -0.69-0.70-0.70-0.60 - - - 5-year -0.15-0.10 0.00 0.10 - - - 10-year 0.48 0.70 0.90 1.10 - - - 2-year -0.33-0.35-0.35-0.25-9 -18 8 5-year 0.25 0.30 0.40 0.50-4 -3-13 10-year 1.05 1.10 1.30 1.50-3 +10 +15 SEK swap curve One month change 2.5 2.0 1.5 1.0 0.5 0.0-0.5-1.0 % bp Change,bp (rhs) 16/05/2017 16/06/2017 0-1 -3-4 -5-6 -7-8 3M Stibor rate 10Y SEK swap rates 7 19 June 2017 www.danskeresearch.com

Norway forecasts At the 4 May policy meeting, Norges Bank reiterated the message from the Monetary Policy Report 1/17: no change in the target rate in 2017 from the present 0.50%. However, the bank s projections suggest a non-negligible probability of a cut. At the upcoming board meeting on 22 June, Norges Bank will release new economic projections. The recent Regional Network report signals higher economic going forward and suggests an upward revision to Norges Bank s growth forecasts. However, inflation has been lower recently than Norges Bank s projection. The strong housing market and the risk to long-term financial stability in the case of a bursting of a potential housing bubble is the main reason for Norges Bank refraining from cutting the target rate. Recently-introduced mortgage market regulations seem to be cooling the housing market somewhat. We forecast unchanged central bank rates on a 12M horizon and a slightly more hawkish Norges Bank at the upcoming board meeting. There is an ongoing public and academic debate on the need for a revision of the current inflation target. Market effects of a potential reform will probably be muted by the fact that the market seems to be discounting moderate inflation already. We expect 5Y and 10Y yields to be stable versus peers in 2017, as the Norwegian economy is improving slowly but is still not out of the woods after the oil-led downturn. NOK forecasts summary NOK Spot +3m +6m +12m +3m +6m +12m Deposit 0.50 0.50 0.50 0.50 - - - 3M 0.89 0.90 0.90 0.90-9 -11 2-year 0.65 0.65 0.70 0.80 - - - 5-year 1.04 1.10 1.10 1.20 - - - 10-year 1.57 1.65 1.70 2.00 - - - 2-year 1.13 1.20 1.25 1.35 +4 +4 +3 5-year 1.45 1.50 1.50 1.60 - -5-6 10-year 1.89 1.95 2.00 2.30 +2 +3 +25 NOK swap curve One month change 2.3 2.1 1.9 1.7 1.5 1.3 1.1 0.9 0.7 % bp Change,bp (rhs) 16/05/2017 16/06/2017 1 0-1 -1-3 -3-4 3M Nibor rate 10Y NOK swap rates 8 19 June 2017 www.danskeresearch.com

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 1.25 1.25 1.55 1.85 2.15 1.36 1.77 2.17 +3m 1.25 1.38 1.70 2.00 2.25 1.40 1.90 2.30 +6m 1.50 1.60 1.85 2.10 2.35 1.60 2.00 2.40 +12m 1.75 1.90 2.25 2.40 2.70 2.00 2.30 2.70 Spot -0.40-0.33-0.18 0.15 0.77-0.63-0.37 0.31 +3m -0.40-0.35-0.10 0.20 0.85-0.65-0.35 0.40 +6m -0.40-0.35-0.05 0.25 0.90-0.60-0.30 0.45 +12m -0.40-0.35 0.00 0.30 1.15-0.50-0.20 0.75 Spot 0.25 0.29 0.53 0.75 1.11 0.18 0.49 1.05 +3m 0.25 0.31 0.55 0.85 1.25 0.20 0.60 1.20 +6m 0.25 0.31 0.55 0.90 1.35 0.20 0.65 1.30 +12m 0.25 0.31 0.55 1.10 1.75 0.25 0.85 1.70 Spot -0.65-0.22 0.02 0.36 1.01-0.55-0.24 0.56 +3m -0.65-0.20 0.10 0.40 1.10-0.55-0.20 0.65 +6m -0.65-0.20 0.15 0.45 1.15-0.50-0.15 0.70 +12m -0.65-0.20 0.20 0.50 1.40-0.40-0.05 1.00 Spot -0.50-0.50-0.33 0.25 1.05-0.69-0.15 0.48 +3m -0.50-0.48-0.35 0.30 1.10-0.70-0.10 0.70 +6m -0.50-0.48-0.35 0.40 1.30-0.70 0.00 0.90 +12m -0.50-0.48-0.25 0.50 1.50-0.60 0.10 1.10 Spot 0.50 0.89 1.13 1.45 1.89 0.65 1.04 1.57 +3m 0.50 0.90 1.20 1.50 1.95 0.65 1.10 1.65 +6m 0.50 0.90 1.25 1.50 2.00 0.70 1.10 1.70 +12m 0.50 0.90 1.35 1.60 2.30 0.80 1.20 2.00 * German government bonds are used, EUR swap rates are used. 9 19 June 2017 www.danskeresearch.com

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