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New yield forecasts

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Yield increases ahead

Thu, Oct 15 2009, 21:15 GMT
by Danske Research Team

Danske Bank A/S

Recent market developments 

Although economic data has been more mixed of lately the picture have on balance continued to improve. In the financial markets equity markets have reached new year-highs and a credit and money markets have improved further. Even so, bond yields have continued to drift lower on a mix of unusual conditions.

Firstly, central banks remain very dovish and does not signal any imminent rate hikes. Secondly, although there are signs, that the recovery has got more traction, it is still perceived
as fragile. Thirdly, the very steep yield curves make it hard to speculate against higher yields, because such positions have very negative carry. Finally, it seems as there is currently an unusual high demand for bond yields due to deleveraging (more saving, less borrow), Asian central bank buying and the potential need for bigger liquidity buffers in commercial banks.

While rate hike expectations have changed little over the past month, the remaining factors have exerted downward pressure on long bond yields, leaving the curves flatter in both US and Euroland.

Macro outlook

The US economy is out of recession and most of key indicators are now consistent with an ongoing recovery. Over the next couple of quarters we expect to see relatively strong growth on back of stimulus driven spending, a re-alignment of production to demand and relief of pent-up demand.

The big issue is whether the initial boost to the economy from these factors, will be sufficient to initiate a self-sustaining recovery. Although there is a minor risk that the recovery could fizzle out, we believe that demand from household and business will be sufficiently
strong by early next year to avoid this. To key issues in this respect is that the labour market begins to deliver jobs from by year-end and that the US personal savings rate does resume its ascend from earlier this year.

Euroland has also pulled out of recession. A combination of a major production backlog and the turnaround in the global industrial cycle is helping exports and at the same time boosting investment. Solid growth in the USA and Asia will benefit Euroland in the coming quarters.

Inflation is not a problem in either Euroland or the USA. Low capacity utilisation and slowing wage growth mean the outlook is for falling core inflation in the coming quarters. Headline inflation will increase as a result of higher commodity prices, but it will remain modest in both the USA and Euroland.

Central banks and bond yields

The Federal Reserve is done with easing monetary policy, and the focus now is on exit strategies from the alternative monetary policy measures. It has ended its Treasury purchase program, but will continue to buy mortgage debt until March 31 2010. Most liquidity measures will expire by March 31 2010, but some not before mid next year. 

The Fed is expected to keep its key interest rate at 0-0.25% for a long time. Inflation is low, and there is abundant spare capacity in the economy, meaning the need for tighter monetary policy is not imminent.

Even so economic growth, the massive supply of Treasuries, the Fed ending its purchase of Treasuries/mortgages and increased risk appetite are expected to lead to significantly higher yields in the coming quarters.

The ECB is expected to hike interest rates next summer, when the upswing has taken a firm hold and the labour market has clearly turned. The ECB is focused on money supply and credit growth, and by next summer the money supply will been growing briskly for quite some time. Besides, the key rate in Euroland is at a historic low. The ECB fears new bubbles, and it has learnt its lesson.

We expect European yields to rise in the coming year as the economic outlook brightens and interest rate hikes move closer. There is also considerable issuance pressure from government bonds in Euroland.

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Published on  Thu, Oct 15 2009, 21:15 GMT