Yield Outlook: ECB to keep long yields down for the rest of 2018

Markets were anxiously awaiting the signals from the ECB's June meeting. As we had expected, a cessation date was announced for QE. Bond purchases will amount to EUR30bn a month until the end of September and then be halved to EUR 15bn for the final three months of the year, after which the programme will cease.

However, the market was prepared for this, and we have not seen any tendency towards the market beginning to price a 'QE premium' out of, or alternatively a 'term premium' into, long bond yields. The ECB did what it could in the spring to convince market participants they should not expect or fear a sudden yield surge as in the US in 2013, when the Fed announced a tapering of QE. That triggered an increase in 10Y US Treasury yields of more than 100bp. See, for example, the speech by ECB member Benoît Coeure from 23 February 2018 for insight into the ECB's position.    

What was important at the ECB's June meeting was the forward guidance. ECB chief Mario Draghi made clear that short-term interest rates would be held at current levels going all the way forward to after summer 2019. Hence, the first opportunity the ECB will have to hike interest rates is now September 2019. As before, we expect the first rate hike to come even later, in December 2019.

Nevertheless, this clear message from the ECB is important. It means market uncertainty of when the QE programme would end and whether the ECB might hike rates early in 2019 has been vanquished 6 and indeed very short rates have subsequently fallen and the market has postponed the expected first ECB rate hike to Q4 19.

Our yield forecast now assumes the market no longer pricing in the probability of a H1 19 rate hike and, as a result, we have lowered our 3M and 6M 10Y yield forecasts slightly. Accordingly, we expect no major upward movements in 10Y Nordic/European bond yields in 2018, even when taking recent yield falls into account. Our 12M forecast for 10Y Bund yields is now 1.0%, down from 1.1% previously. Still, on a 12M horizon we do expect the market to begin pricing rate hikes for late 2019 and through 2020, which would tend to push long-term yields up a bit, as indicated in the chart above.

We continue to expect a steeper 2Y10Y German yield curve. The ECB maintains a relatively tight grip on the short end of the curve, especially with the first ECB rate hike not expected until late in 2019 and due to the ECB's forward guidance. However, we still expect the 10Y segment of the curve to be pushed higher by US yields in 2019 and by the market pricing ECB rate hikes in 2020. We continue to see 10Y US Treasury yields at 3.30% on a 12M horizon. Unlike the situation in the European markets, we expect the 2Y10Y US yield curve to flatten further over the next twelve months.

We continue to expect the 2Y USD/EUR yield spread to widen further. The Fed will likely hike two more times this year and continue hiking next year. In that context, we would also emphasise that we still expect the Fed funds rate to go higher than 2.75% (which is the Fed's estimate of the natural rate of interest given a normal state of the economy) in the coming years.