A second US rate hike is drawing closer

– Something is brewing in Japan: the yen is likely to fall

– The ECB awaits the impact of its latest easing package

– DKK strengthens further against EUR

– A second US rate hike is drawing closer

Market overview

DKK strengthens further against EUR

The DKK strengthened further against the EUR in May, with EUR/DKK now trading below 7.4400. A considerable discount is still apparent in the forward market around the 1-2Y section of the curve, though not on the same scale as at the start of April. EUR/DKK is slowly but surely approaching the trough reached at the start of 2015, so we expect it will be only a matter of time before Danmarks Nationalbank (DN) will have to intervene in the FX market to support EUR/DKK. The reason is, not least, that going forward we expect the DKK to be supported by a narrow rate spread to the ECB, low liquidity in the DKK market, potential foreign buying of DKK in connection with DONG Energy’s imminent stock market listing (possibility of it being 10 June) and, finally, uncertainty about the potential fallout for the EUR from the UK’s referendum on EU membership, which may stoke investor interest in Danish assets.

A second US rate hike is drawing closer

The US central bank, the Federal Reserve, appears to be warming to a rate hike at one of its upcoming meetings. That was, in any case, the signal from the minutes of the April monetary policy meeting and the latest comments from Fed members. The market is not currently prepared for a rate hike in the coming months, pricing in a 60% probability in June and an 80% probability in September. As a result, the more hawkish signals from the Fed have strengthened the USD and caused commodity prices to retreat. We continue to expect a US rate hike in September, which will probably be the only hike this year.

UK Brexit referendum fast approaching

Opinion polls still indicate a near dead heat in the UK referendum on continuing EU membership on 23 June. The ‘remain’ camp is, however, ahead in most polls, with its lead even increasing in some surveys, which has supported the GBP. However, uncertainty will probably continue to cloud financial markets in the final month ahead of the vote.

US oil production down

The low oil prices have long been having consequences for investment in the US oil sector and for the number of new oil wells, both of which have fallen. Actual oil production has now also begun to fall – recently by more than the market was pricing in – which has lent support to the recovery in oil prices. North Sea Brent is now trading at around USD49/bbl, which is more than 50% up on the early February low. Given the outlook for a stronger USD in coming months and the risk of a growth slowdown in the wake of the UK referendum on EU membership, we see little potential for further price increases in the short term. Our forecast for next year is an average oil price of around USD54/bbl.

Interest rate hedging

• We expect continued downward pressure on global yields in coming months, given the ECB’s increased QE purchases.
• We recommend that borrowers take advantage of any fall in interest rates in coming months to increase the proportion of fixed-rate debt in their debt portfolios. ECB patiently awaiting impact of latest measures

The ECB is now implementing the easing measures it announced in March, including further loans to the banks (TLTRO II) and an expansion of government bond purchases from EUR60bn to EUR80bn per month. We therefore do not expect the ECB to launch any new initiatives over the summer, when it is likely to instead focus on the impact of the easing measures on the economy. Mario Draghi said at the ECB’s April meeting that monetary policy is working but that patience is needed.

Looking further ahead, we expect the ECB to extend bond purchases beyond March 2017, as inflation does not really appear to be picking up. In our view, the ECB is unduly optimistic on the core inflation outlook and is likely to regularly revise its projections lower.

The latest round of monetary policy easing means we are unlikely to see any major increase in Eurozone bond yields and we would definitely not rule out the possibility of further downside pressure on yields over the next few months. The ECB’s new easing measures could well result in Germany being the next country – after Switzerland and Japan – to experience 10Y bond yields slipping into negative territory. Nevertheless, we still expect modest upward pressure on yields on the 6-12M horizon due to a spill-over from the long end of the US yield curve, though we remain convinced the ECB can keep 2Y and 5Y yields anchored via QE purchases and a deposit rate of -0.4%. We therefore still expect the 2-10Y and 5-10Y euro curves to steepen somewhat. We also expect 3M EURIBOR fixings to remain negative for the coming 12 months.

Fed hike in September

US yields have moved higher in recent weeks as some of the more hawkish FOMC members are still saying that a June hike is a possibility. Especially FOMC chair Janet Yellen’s comments on 27 May that ‘it's appropriate for the Fed to gradually and cautiously increase our overnight interest rate over time’ and that ‘probably in the coming months such a move would be appropriate’ have supported a repricing of the FOMC

Currently, markets have priced in a 30% probability of a June hike; however, we think the April jobs report closed that door. Employment rose by 160,000 in April, which was the lowest increase in seven months and now we have a combination of a significant slowdown in terms of GDP growth in Q1 and slower employment growth. Instead, we still call for a 25bp rate hike at the FOMC meeting in September. However, the likelihood of a summer hike has indeed increased as US growth seems to be back on track following a couple of weak quarters and we see potential for further repricing at the short end of the US yield.

We expect the next three to six months to see a further flattening of the 2Y10Y curve as more Fed hikes are priced in and as investors ‘hunt’ the higher US yields. Hence, there will be little scope for higher 10Y yields. Eventually the Fed should, however, resume its hiking cycle, causing US yields to trend higher. The move higher in US yields is mainly expected on six- and 12M horizons. Our forecasts for US rates on a 12M horizon are above the forward market.

EUR curve hedging recommendation

As we expect the downward pressure on long yields to continue in the coming months, we maintain our general recommendation of modestly underweighting duration on the liabilities side on the EUR curve. We continue to expect long yields to trend higher in the medium term and recommend capitalising on any fall in interest rates to increase the proportion of fixed-rate debt in debt portfolios. Long-term yields surged in April 2015 following an extended period of significant yield falls. We would not rule out a similar scenario happening again – though we do not expect it – and therefore recommend that borrowers consider gradually adding fixed-rate debt as interest rates fall. We continue to see most value at the long end of the yield curve, i.e. from 10 years and beyond on the EUR curve.

USD curve hedging recommendation

We still recommend having a relatively high hedge ratio on USD liabilities and locking in rate exposure at all maturities from 2Y and beyond, as US rates are likely to trend higher in the coming year. However, as we generally expect global yields to be under pressure in the coming months, we maintain our liability duration recommendation slightly below maximum.

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