The rally in the Euroland bond market has been of a historical magnitude lately. The 2-year German yield has fallen from its summer peak of 4.7% to the current level of 2.25%. This may seem overdone, but the extraordinary move is due to an extraordinary change in the drivers of the bond market:
Growth has continued to surprise on the downside, with increasing evidence that the weakness now extends to all parts of the world and all sectors. Both the IMF and OECD now predict negative growth rates in Euroland next year.
Inflation pressures continue to decline, as oil prices have fallen massively from the highs of USD 150 to the current level of USD 55, which will lead to a rapid decline in inflation over the next 6-9 months.
ECB has shifted to a dovish stance with rate cuts of 50bp two months in a row, and we expect a further 50bp cut in December.
Risk aversion remains high, as equity and credit markets have struggled again lately. This will support government bonds as investors seek safety.
The market is now pricing ECB rates to go to 2%. Even though this is a bit below our own forecast of 2.25% by June 2009, we see further downside for bond yields, as the market will likely price some probability of ECB rates going much lower due to fears of a depression (see New Yield Forecast). Note that the OECD this week predicted ECB rates would hit 2% in the coming quarters. The decline in yields will increasingly benefit the Danish economy, as we expect the Danish Central Bank to not only follow the ECB lower but also to narrow the rate spread to Euroland. This will lead to substantial declines in Danish bond yields and lend support to the Danish housing market.
