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New yield forecasts

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Euro−zone yields set to fall

Tue, Apr 1 2008, 12:50 GMT
by Danske Research Team

Danske Bank A/S

Macro outlook

• • The economic outlook is still very gloomy, with the US on the brink of a recession. The housing market correction is far from over, the credit crisis means credit conditions will keep tightening, stock markets have fallen and the surge in food and energy prices has driven inflation to a high level. Also, labour mar-ket dynamics have turned around and unemployment is rising. Consumer spending is having a rough time at the moment, and GDP growth is set to be modest in the coming quarters.
  

• • However, the US has eased economic policy significantly to offset the slowdown in growth, and the dol-lar’s weakening is lending a hand to exports. We expect an upswing to take off some time in 2009.
  

• • In Euroland, the dilemma of rising inflation and deteriorating growth prospects is becoming ever more evident. Consumption growth was never extravagant in the latest expansion and is now hard hit by high inflation, which is eroding consumer purchasing power. Meanwhile, several housing markets are faced with growing problems. Export growth is heading down and investment growth is also slowing. Hence, Euroland has no strong growth engine to drive its economies forward. We expect the growth outlook to deteriorate gradually during 2008. This will become evident in the coming months, for instance, as PMI data continue to deteriorate.
  

• • Euroland inflation has kept increasing, hitting 3.5% in March. This is far above the ECB’s target, and in-flation has thus risen more than expected. The latest rise in inflation has been driven especially by food and commodity prices. We believe inflation will begin to slow down in the very near future, but it will probably be a very long time before it falls below the ECB’s target.
  

• • Please see Global Scenarios for a detailed discussion of the economic outlook for the US, Euroland and the Emerging Markets.
  

Central banks and bond yields

• • The Fed has eased aggressively in response to the sharp weakening of growth prospects. We believe that the FOMC will cut rates by another 75bp at its next two policy meetings, taking the fed funds rate down to 1.5%. We expect the US economy to stabilise in the autumn of this year on the back of the sig-nificant easing of monetary and fiscal policies. Combined with the inflation worries, this will put an end to the Fed’s easing cycle.
  

• • US yields could fall further in the short term but will increase on a longer-term horizon as the economy stabilises and the easing cycle draws to a close.
  

• • High and increasing inflation prevents the ECB from cutting rates at the moment in spite of the deterio-rating growth outlook. Therefore, we have postponed the forecast first rate cut from June to September. We are still forecasting three rate cuts in the coming 12 months. We are confident about our growth forecast – growth is pretty sure to slow down – but inflation is the joker in the pack. A continued surge in commodity prices could further postpone the turnaround in inflation and the expected rate cuts. How-ever, the continued strengthening of the euro will put a damper on growth and inflation.
  

• • Slowing growth and inflation, together with rate cuts, will push down Euroland yields over time.
  

Yield curves

• • The US yield curve might steepen further in the coming months as the Fed cuts rates more than the market is expecting and short yields fall. The yield curve should flatten again during the summer of 2008 as it becomes evident that the Fed is done easing and short rates increase.
  

• • In Euroland, the slope of the yield curve will depend mainly on the ECB’s action and expectations for monetary policy. We expect the Euroland yield curve to steepen gradually as the economic outlook wors-ens and the rate cuts draw closer.
  

Country spreads

• • We believe that especially the divergence in monetary policy will dictate the relative performance. US bonds could outperform their German counterparts in the very short term, but Europe will take the yel-low jersey when it becomes clear that the Fed is done easing and the ECB is ready to start easing.

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Published on  Tue, Apr 1 2008, 13:01 GMT