Growth and inflation
GDP increased by 0.2% q/q in Q3. Q3 growth was driven by decent private consumption and good numbers from Germany and France. Economic indicators, such as PMIs and Ifo, remain at recession levels while retail sales and industrial production seem to have embarked on a declining trend. We forecast that the euro area is heading for a mild recession, with GDP dropping 0.3% q/q in Q4. Fiscal policy is being tightened, implying that the peripherals are set for negative GDP growth and also 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 2011E and only 0.3% in 2012E. Inflation should remain above the ECB.s 2% target throughout 2011 before edging below 2% in spring 2012.
Monetary policy and money markets
The ECB cut its key policy rate by 25bp again in December. Furthermore, the ECB introduced 36-month LTRO and eased the collateral requirements, which should ease the funding conditions for the banking sector. Despite Draghi declining to commit to further policy easing, we expect the ECB to cut by another 25bp in January, taking the refi rate to 0.75%. We expect the ECB to narrow the rate corridor by 25bp to +/- 50bp. Hence, the deposit rate will not be lowered to less than 0.25%, while the marginal lending rate will be cut from 1.75% to 1.25%. Euribor fixings are moving lower, but only slowly due to the stress in the European money markets. We expect faster declines in the coming months, as the ECB cuts rates, tightens the corridor and keeps the market awash with liquidity.
Yield curve
Swap rates are expected to decline over the coming three months, as economic data will remain weak, the ECB will cut rates further, and the risks regarding the European debt crisis are set to dominate. There is most downside to short rates, due to our expectation of more ECB cuts and our view of a relatively fast decline in fixings early next year. An improved macro picture in the US and soon China is set to counter some of the downward pressure on rates for long maturities. Therefore there is still decent potential for curve steepening. Our forecasts are generally below the forward market. However, we look for a bottom in long rates in Q2 12, reflecting a stabilisation in the euro area by that time and an improved global growth picture. Our 12-month forecasts for 10- and 30-year swap rates are above the forward market.
US forecast
Growth and inflation
Growth in the US has recovered from the weakness in H1 and rose to 2.0% in Q3. Based on economic key figures, GDP growth in Q4 is tracking 2.5-3.0%. The labour market has also improved with US non-farm payrolls averaging 140,000 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% through 2012. ISM manufacturing has risen gradually and we expect it to continue to rise towards 55 over the coming months. Inflation pressure has eased somewhat recently as commodity prices have declined. Pric-ing 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 stay sidelined for now as the economy is recovering. A change in communication strategy is likely to come early in 2012 when 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 keep long-term yields lower by further QE. Further easing by the Fed is possible in 2012 if the fragile recovery faces new headwinds. The money market is pricing no Fed hikes before well into 2014. However, in response to the squeeze in the USD funding market, 3M USD Libor fixings have continued higher and are now yielding 0.543%. This trend could continue as long as the European debt crisis evolves.
Yield curve
The US yield curve is caught between improving US macroeconomic indicators versus the ongoing debt crisis in Europe and slowing growth elsewhere in the world. Going forward, much depends on the debt crisis in Europe. With uncertainty remaining high and the Fed retaining its easing bias, US bond yields are likely to remain caught in the recent range for the remainder of the year, despite our expectation of some further improvement in the US economic indicators. We emphasise that volatility is likely to remain high and that the market will be very sensitive to both positive and negative news regarding the debt crisis. Even though the US cyclical picture is improving, our forecast for a gradual rise in long rates is only likely to be proven right if financial stress eases off. We have made very few adjustments to our forecasts. Our forecast for five-year maturities and higher is slight above the forward market, with the biggest difference on a 12-month horizon.
UK forecast
Growth and inflation
The UK economy might already be in recession even though official numbers haven‟t confirmed this yet. Unemployment is at its highest level for 15 years and is likely to rise further. Consumer and business sentiment is worsening and disposable income for households is falling. Access to credit is diminishing as banks are struggling. The UK economy is in slightly better condition than the average eurozone country but the difference is not big. 2012 growth will lower than 1.0%. The UK risks being downgraded next year (see How long can the UK maintain its AAA rating dated 7 September 2011).
Monetary policy and the money market
The Bank of England increased the ceiling for asset purchases by GBP75bn to GBP275bn in October in an attempt to boost the economy. We reckon that gains from quantitative easing are somewhat questionable and there might be adverse effects which are hard to grasp. It is in our view unlikely that the economic outlook will improve substantially over the coming months and we expect the Bank of England to announce another GBP50-75bn increase in the asset purchase target in January 2012. We do not think the Bank of England will cut the base rate but the Special Liquidity Scheme (SLS), which ended mid-2010, could be revived if the central bank decides to address some of the issues in financial markets and improve the poor liquidity in the interbank market.
Yield curve
The UK yield curve is extremely flat, effectively pricing „seven lean years‟ as the governor put it in one of his speeches. We agree overall with the current pricing and our forecasts reflect our bleak macroeconomic projection. We recommend corporate clients to pay fixed and receive floating, especially at longer maturities. If the Bank of England revives the SLS, Libor forwards could decline. Accordingly, speculative investors might consider positioning for lower Libor forward rates, for example, by buying the three-month short sterling contract.
Denmark forecast
Growth and inflation
GDP dropped 0.8% q/q in Q3, which was expected due to the recent deterioration of export demands. However, the breakdown revealed that the large drop was primarily the result of falling domestic consumption – most notably a large drop in public consump-tion. Looking ahead, the expected mild recession in the euro area in Q4 11 and Q1 12 is expected to lead to a further decline in Danish economic activity and it is therefore highly likely that the Danish economy will fall into a new recession in Q4. For the whole of 2011 we forecast the Danish economy to expand 0.7% y/y and in 2012 to expand 1.0% y/y. Despite the drop in economic activity inflation remains elevated above 2.5% y/y. However, this is mainly due to a base effect from the new tax on fat introduced on 1 October this year, which has increased annual inflation by 0.3%.
Monetary policy and money markets
Following another period of upward pressure on the Danish currency, the Danish central bank cut the lending rate by 40bp to a record low of 0.80% (20bp below the ECB refi) and the CD rate by 25bp leaving it at 0.40%. We believe that the Danish central bank will follow the ECB and cut the lending rate by another 35bp in January, taking it to 0.45%. The CD rate is forecast to be kept at 0.40%, as we do not expect EONIA rates to move persistently below 0.40% with an ECB deposit rate at 0.25%. However, risks are skewed for another cut in the CD rate. The Danish money market is only factoring in limited declines in rates, so we continue to see decent potential for lower Cita rates and Cibor fixings in the months ahead.
Yield curve
Foreign investors have increasingly been viewing Denmark as safe haven with the euro crisis continuing to intensify. This caused solid performance of Danish bonds and swap rates, which are trading through German yields and rates. We expect Danish rates to remain below the German ones for some time, as the euro crisis will continue to dominate going into 2012. Down the road we think Danish rates should trade relatively close to German rates. Our forecasts for Danish swap rates are below forwards on all forecast horizons.
Sweden forecast
Growth and inflation
Q3 showed q/q GDP growth of 1.6% and is likely to be the last in this cycle with strong momentum; however, this was partially due to unintended inventory accumulation in the retail sector. Basically, due to the continued turmoil in Europe, the outlook for the Swed-ish economy has deteriorated quite markedly in Q4. Forward looking indicators such as PMI and similar business sentiment indicators are solidly in the contraction area. Finan-cial conditions are tightening due to continuously rising money market rates resulting in higher short-term mortgage rates. Consumer spending is under pressure. GDP might in fact contract even in Q4. Inflation is modest indeed. Excluding mortgage rates inflation came out at only 1.1% y/y in November, two tenths below the Riksbank‟s forecast. We expect inflation to remain under pressure over the coming year.
Monetary policy and the money market
As mentioned above, the Swedish money market has been affected by the tension in Europe. STIBOR fixings are rising (currently trading at a spread of 73 basis points over the repo rate). In a way, this means that the Riksbank is not in full control of the transmis-sion mechanism right now. Unemployment is likely to turn up again and this in combina-tion with very low inflation provides a strong argument for the Riksbank to ease monetary policy. We expect a first 25bp cut in December. However, it is not evident that such a move will have much effect on money market rates and rates to consumers and busi-nesses. If this is the case, the Riksbank will probably have to add liquidity to the market by reintroducing SEK lending facilities.
Yield curve
Despite the fact that repo rate cuts equal to some 110bp have been discounted by the market over the next year, we still think that the bond curve will steepen during the course of next year. A combination of lower short rates and eventually higher long-dated rates will make the bond curve steeper. A low inflation rate and the Riksbank being forced to pour more liquidity into the financial market suggests lower rates at the front end. At the long end of the bond curve the rates are at an all-time low and we suspect that later in 2012 these rates will inch higher as growth slows. In the short term, the curve might struggle to steepen as long as short funding rates continue to climb. This is particu-larly true for the swap curve.
