Latest market developments: After a brief period of post-Christmas cheer, gloom has once again de-scended on equity markets. This together with a steady stream of bad news and falling inflation has sent both US and European yields down once more.
Macro outlook: The US economy is still in free-fall. The breakdown of the credit market, tumbling equities and still falling house prices combined with rapidly rising unemployment have send the economy spiralling down. GDP fell sharply in Q4 08, and we are looking for a further fall in Q1 09. Nevertheless, we expect to see a gentle upswing in H2 on the back of fiscal easing, low inflation (which supports real incomes) and im-proved pass-through of monetary policy as the financial system rights itself.
The European economy continues to deteriorate. Tighter credit, increasing housing market woes and a pronounced slowdown in exports on the back of the global slowdown have hit most of Euroland. The outlook for growth will remain gloomy most of the year. Falling commodity prices mean that inflation will undershoot the ECB target in 2009.
Central banks and bond yields: The US Federal Reserve will maintain the fed funds rate at 0-0.25% for an extended period and continue its quantitative easing of monetary policy, for instance via buying credit pa-pers at the long end of the curve. We generally expect yields to range trade three months forward, but with relatively high volatility. The fixed income market will turn around in the course of the spring as the economy stabilises and the outlook improves.
The recession continuing and very low inflation will cause the ECB to cut rates by 50bp in March. This will bring the key rate down to 1.5%, which is what the market is already pricing in. Hence, in our view, the scope for lower yields in Europe is very limited. While the risk remains downside in the very short term, we generally expect that the European fixed income market will move sideways for the coming 3-6 months. Yields will rise again in H2 when the outlook improves.
Yield curves: The slope of the US yield curve is expected to remain unchanged in the short term, As the economy begins to stabilise, long yields will rise as the quantitative easing of monetary policy is phased out. Not much change is expected in the slope of the European yield curve over the coming 3-6 months. In the longer term, the yield curve will flatten again.
Country spread: European bonds will outperform their US counterparts, as Europe will lag the US in terms of both monetary policy and the economic cycle.
