Waiting for the central bank response

The sell-off in risky assets has continued over the past month and the move into safe fixed income assets such as US treasuries and Bunds has intensified and the outright 10Y yield level in, for example, Germany has fallen to a level not seen since April 2015. The fall in yields has gone hand in hand with rising fears of a more severe global slowdown in the world economy in a situation where global inflationary pressure is already very low. Market-based inflation expectations in both the US and the euro area have decreased throughout 2016, which has helped drag nominal yields lower.

The move lower in 10Y US and German yields has also been triggered by a big change to monetary policy expectations. The market now expects the ECB to cut rates by 10bp at the March meeting and follow this with at least one more rate cut in 2016. In the US, the market has completely priced out the probability of rate hikes in 2016. The first hike is not priced before late 2017 and the market has been flirting with rate cuts in 2016.

ECB President Mario Draghi had a very dovish tone at the latest ECB meeting at the end of January and we now expect the ECB to cut the deposit rate by 10bp at the March meeting accompanied by a two-tier deposit rate system aimed at limiting the costs to the banking sector. We also expect the ECB to front-load QE purchases with EUR80bn per month in March to May but to maintain the total size of the programme.

The weaker growth and inflation outlook for the eurozone and further easing from the ECB mean the earlier projected modest rise in 10Y government bond yields now looks distant. Given our view of front-loading of QE by the ECB and the risk of a further weakening of the risk sentiment, there is certainly a possibility that Germany could be the next country after Switzerland and Japan to experience negative 10Y yields. However, we still see upward pressure on a 12-month horizon, as we still expect upward pressure on the long-end of US yields later in 2016. We still firmly believe the ECB will be able to keep 2Y and 5Y yields in check with QE purchases and a deposit rate at -0.4%.

Also, in the US, there is little scope for higher yields over coming months. We believe the Fed will strike a more neutral bias at the next FOMC meeting However, we still hold the view that the stress will eventually ease and the Fed will resume its hiking cycle, not least because the unemployment rate is at a very low level. A resumption of the hiking cycle should once again cause US yields to trend higher, although long-term yields are pushed down by easier monetary policies from the ECB and Bank of Japan.

Still more easing in Scandinavia
The Riksbank reacted to the low inflation at the policy meeting last week and slashed the deposit rate by 15bp to -0.50%. We do not see more rate cuts in Sweden but another expansion of the QE programme. In Norway, the low oil price is likely to trigger a final rate cut next month, to 0.50%, and finally Denmark is on the margin expected to follow the ECB lower, bringing the deposit rate back to -0.75%.

Arne Lohmann Rasmussen
Chief Analyst
Danske Bank