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New yield forecasts

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ECB to ease aggressively − yields will fall further

Fri, Nov 21 2008, 15:21 GMT
by Danske Research Team

Danske Bank A/S

Latest market developments: Given the very bleak economic news lately, we have decided to revise our forecast for the ECB, which is now expected to ease more aggressively in the coming months (see Flash Comment Euroland: Very weak PMI should spur ECB to cut rates dramatically). This also means new esti-mates for long yields. Movements on the equity market often set the agenda for the fixed income market, and the combination of falling equity prices and bleak economic news has added extra impetus to the fall in yields recently.

Macro outlook: The US economy has been hit by a sharp tightening of credit to both households and busi-nesses. Moreover, consumer spending is reeling under falling employment, big stock market losses and a continued decline in house prices. GDP fell in Q3 and is likely to contract further in the coming quarters. We could hope for a modest recovery in H2 09 on the back of fiscal easing, a boost to real income from a turn-around in inflation and better monetary transmission as the financial system recovers.

The latest decline in business confidence shows loudly and clearly how bad the situation is in Euroland - for example, PMI is at 36.2, a historical low. European banks are also tightening credit conditions, and housing market problems are growing in several countries. Euroland will probably need a helping hand from the global economy to kick-start its economy. Hence, the growth outlook for the euro zone will remain gloomy long into 2009. That said, falling commodity prices mean euro-zone inflation will come down rapidly, so there is a good chance the ECB's 2% inflation target will be met as early as in spring next year

Central banks and bond yields: The outlook is for a further and perhaps final rate cut of 50bp in the US in December, though there is a risk of additional cuts. Still weak economic data, increasing fears of deflation and a soft tone from the Fed mean we expect further falls in long government yields. Short swap rates could fall further in the near term due to a narrowing of swap spreads resulting from a gradual normalisation of the money markets. The reverse is true of long swap rates, where spreads have narrowed due to ALM hedging. We expect that spreads will widen gradually as hedging eases. In the longer term, we expect yields to rise again as a result of the economy recovering.

The very serious economic situation will cause the ECB to cut its policy rate by 75bp in December, 50bp in January and a further two times 25bp in February and March, bringing the rate down to 1.5%. This will pave the way for further falls in long yields over the next couple of quarters. Swap rates in particular are ex-pected to fall on the back of further monetary easing, bleak economic news and an improving money market and thus less difference between swap rates and government bond yields.

Yield curves: The US yield curve is expected to steepen in the short term but flatten longer term as the economy stabilises next year. In the euro zone, the yield curve is likely to steepen over the next 3-6 months as yields decline and monetary policy is eased. In the long term, the yield curve should again flatten a little.

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Published on  Fri, Nov 21 2008, 15:28 GMT