International Yield Forecast: Long Rates Close to a Trough

Eurozone forecast  Growth and inflation

The economic data are consistent with the eurozone being in a recession in Q4 11 and going into 2012. However, there are tentative signs of stabilisation in activity, albeit at low levels. We forecast that GDP has fallen 0.3% q/q in Q4. Fiscal policy is being tightened, implying that the peripherals are set for negative GDP growth and the core is suffering. Due to the headwinds from fiscal tightening and turmoil in the financial markets, we expect the euro area economies to grow 1.6% in 2011 and only 0.3% in 2012. Inflation should remain above the ECB‟s 2% target over the next few months before edging below
2% for a prolonged period.

Monetary policy and money markets
In January, the ECB kept the leading interest rate unchanged at 1% as expected. The decision was unanimous. We expect the ECB to keep rates on hold for a prolonged period of time – possibly until 2014 – as the economy slowly improves but risks are skewed on the downside. The ECB may deliver further rate cuts and more non-standard measures if downside risks materialise. The 3Y liquidity tender carried out in December, and to be repeated on 29 February, has brought significant relief in financial markets. Euribor fixings are declining at a rapid pace, something we expect to continue over the next few months, which is leaving downside pressures on rates up to 2Y. Our forecasts are slightly below forwards in the short end of the curve across forecast horizons.

Yield curve
We believe that 10Y US rates have troughed now and we see increased upside risks to long-dated US rates. In combination with easing stress in European markets, we think that longer dated EUR swap rates have also bottomed out. However, we see limited upside for EUR rates over the next three months due to the uncertainties prevailing. We thus expect 10Y EUR rates to be range bound for the next few months, before edging higher on 6M and 12M horizons. We have lifted our forecast slightly. On a 3M horizon our forecasts are in line with forward markets, while they are above forwards on 6M and 12M horizons.   

US forecast

Growth in the US has recovered from the weakness in H1 and rose to 1.8% in Q3. Based on economic key figures, GDP growth in Q4 is tracking 3%. The labour market has also improved, with US non-farm payrolls averaging 137,000 over the past three months.

Private consumption has recovered following a soft patch in H1. Looking forward, we expect GDP to grow moderately by around 2.5% in 2012. ISM manufacturing has risen gradually and we expect it to continue to rise towards 55 over the coming months. Inflation pressures have eased somewhat recently, as commodity prices have declined. Pricing power is poor and wage increases very muted. We expect core inflation to peak just above 2% in coming months and decline towards 1.5% in 2012.

Monetary policy and the money market
We expect the Fed to remain on the sidelines for now, as the economy is recovering. A change in communication strategy is likely to come early this year and the Fed may opt to publish an expected Fed funds path, which may help it anchor longer term yields. This would be seen as an alternative to keeping long-term yields lower by further QE. We do not expect further easing in 2012 but it is possible if the fragile recovery faces new headwinds. The money market is pricing no Fed hikes before well into 2014. There are signs of stabilisation in 3M USD Libor fixings as the ECB has eased collateral requirements for EUR funding and the Fed has cut the penalty on USD swap lines to 50bp. We expect
stable to lower USD fixings.

Yield curve
The US yield curve remains caught between improving US macroeconomic indicators versus the ongoing debt crisis in Europe and slowing growth elsewhere in the world. Much depends on the debt crisis in Europe. However, with signs of easing stress in the financial markets, declining short-end funding rates for European sovereigns and continued healthy macro data out of the US, we believe that 10-year swap rates have troughed. We expect long rates to move higher and forecast a steeper curve. In our view, the risk of a sell-off is gradually increasing. We have made very few adjustments to our forecasts. Our forecast for five-year maturities and higher is above the forward market, with the biggest difference on a 12-month horizon.

UK forecast

The recent stream of UK data has been better than most had foreseen but economic growth was absent in Q4 and Q1 is likely to be challenging. A mild recession cannot be excluded but it is likely to be a close call. Output remains below the pre-crisis level and recovery is something that belongs to H2 12. Private consumption is picking up and we expect consumer sentiment to improve when affordability returns, as inflation comes down. CPI remains elevated but is set to fall rapidly towards the Bank of England‟s (BoE) 2% target.

Monetary policy and the money market
The Bank of England lifted the asset purchase target by GBP75bn to GBP275bn in October. The Gilt purchases will be finalised at the end of January and we expect the BoE to lift the asset purchase target by another GBP50bn, to GBP325bn, in February, as the economy still needs additional stimulus. By the end of 2012, we think the BoE will have bought GBP400bn Gilts in total. At present, we think the BoE will stick to Gilts and will not increase the pace of purchases. The rise in Libor rates since August must be worrying for the bank though; interbank liquidity is tightening despite the BoE maintaining its asing bias. Unless Libor rates stop creeping higher, we think the BoE will have to revive the Special Liquidity Scheme, which effectively improved the liquidity situation in 2008.

Yield curve
The UK yield curve is extremely flat, effectively pricing „seven lean years‟ as the Governor put it in one of his speeches last year. Markets are for example pricing only a 40bp rise in the 10-year rate on the one-year horizon and a 30bp steepening of the 2/10-year curve. Despite more QE, we could see both rising slightly more as H2 could be less depressing than generally thought, especially if we are right that private consumption will pick up. We expect Gilts to remain a safe haven as long as the eurozone crisis is a market theme and the UK government sticks to its deficit reduction plan. We recommend corporate clients pay fixed and receive floating, especially at longer maturities.

Denmark forecast  

The Danish economy is looking to fare quite well in the midst of the eurozone recession. Private consumption picked up by the end of last year and exports remain robust. Looking ahead, the new government is planning a fiscal expansion this year, which would add to growth. However, the drawback of this manoeuvre is an increase in the budget deficit and slower growth in 2013 on the back of necessary fiscal contraction. We see the Danish economy growing around 1% y/y in both 2012 and 2013. The introduction of the new fatty tax last year and new duties this year is likely to keep inflation elevated despite low capacity utilisation. We forecast prices will rise 2.1% y/y this year and 1.9% next year. 

Monetary policy and money markets
Following another period of upward pressure on the Danish currency, the Danish central bank cut the lending rate by 10bp to a record low of 0.70% and the CD rate by 10bp, leaving it at 0.30% in December. As risk sentiment in general has improved since then, the flows into Danish assets appear to have declined. EUR/DKK is stable and interest spreads to EUR markets have turned less negative. We believe that the Danish central bank will keep its policy rates unchanged going forward. However we cannot rule out further independent cuts in the REPO rate should inflows accelerate again. We think the Central bank will be more hesitant in lowering the Account Credit rate (currently at 0.25%) below the ECB deposit rate (currently at 0.25%). We expect Cibor fixings to resume their downtrend but at a slower pace than recently seen and at a slower pace than the pace of decline in Euribor fixings.  

Yield curve
With the improvement in the general appetite, Danish bonds have underperformed German bonds, and the negative swap spread between Denmark and Germany has become less negative. While we expect Danish rates to remain below German ones for some time, as the euro crisis will continue to affect markets , we think that Danish rates should trade relatively close to German rates down the road. Our forecasts are in line with forward
markets on a 3M horizon, while they are above forwards on 6M and 12M horizons.

Sweden forecast

Recent data suggest that the Swedish economy slowed significantly late last year. Orders for manufactured goods registered a 10% decline in the last four months through November with export orders for investment goods falling as much as 25%. In addition, retail sales continued to be tame with only a marginal improvement in December despite unusually large discounts on clothing. This is a quite important signal that the fourth quarter will be much softer from a growth perspective. In fact, GDP is likely to be in negative territory on a q/q basis.

Monetary policy and the money market
The minutes from the Riksbank‟s December policy meeting (when it decided to cut the repo rate by 25bp) revealed that several board members are in “wait-and-see” mode with sustained considerable political and economic uncertainties as far as the euro area is concerned. The December meeting was based on an update of the forecast made in October. Full revision of the forecast (monetary policy report) will be made for the policy meeting on 16 February. With a GDP forecast for this year of 1.7% the RB now ranks among the true optimists. For instance, the National Institute of Economic Research in its December projection lowered the 2012 estimate to 1.0% and in our view that too is probably on the
optimistic side. Therefore we believe that the RB will lower growth estimates and the rate forecast in February and deliver another rate cut.

Yield curve
Despite the fact that repo rate cuts equal to some 85bp are discounted by the market over the next year we still think that the bond curve will steepen during the course of the year. A combination of lower short rates and, eventually, somewhat higher long-dated rates will render the bond curve steeper. At the long end of the bond curve the rates are at an all-time-low and the Debt Office will launch a new 20y bond in the spring, which might cool longer yields a bit ahead of the issuance of the bond.

Norway forecast

The Norwegian economy is now feeling the first effects of the European crisis, most notably in the form of weaker exports and tighter credit conditions. High oil prices are fuelling further strong oil investment, which is lessening the impact of the crisis and limiting the downside risk to the Norwegian economy. Improved terms of trade also mean strong growth in real household disposable income, which is being amplified by low interest rates and inflation. Private consumption and housing investment are therefore also set to perform well. Greater global uncertainty and more restrictive credit policies are likely to dampen investment growth.

Monetary policy and the money market
Norges Bank decided to cut the deposit rate aggressively by 50bp in December to 1.75% to accommodate rising financial tensions and weaker economic outlook. We do not look for further cuts. The turmoil in Europe will probably bring unchanged interest rates for most of 2012. We expect Norges Bank to reinitiate the tightening cycle in late 2012.

Yield curve
We expect the Norwegian 2-10 swap curve to steepen over the course of 2012. The short end will be kept low due to the central bank being on hold. Meanwhile, we expect the long end of the curve to have bottomed in line with European and US longer dated rates.