New Yield Forecast: Yields up on growth optimism

Recent market movements
Global bond yields have  increased sharply over the past month. The  upward move has
primarily been driven by the US Treasury market, with long Treasury yields, in particular,
surging on the back of improved data, increased risk appetite and additional tax cuts for
US households.

Another important reason for the rise in yields remains the squaring of positions ahead of
New Year – in a thin market close to year-end this has reinforced the effect of the positive
news stories. US 10Y Treasury yields have risen by more than 100bp since October.
As European yield increases have been less pronounced, spreads to the US have widened
at the long end of the curve.

Macroeconomic outlook 
In the US, the growth rotation from manufacturing towards the service industry continues.
This has increased the chances of the recovery gaining traction and has boosted job creation. Furthermore, indications are that the slowdown in manufacturing industry will not
be as severe as expected earlier and there is the prospect of manufacturing activity picking up again in early 2011. We expect the ISM index to bottom out at around 53 in the
coming quarter and then begin to rise. Overall economic growth is therefore expected to
accelerate to above trend in 2011. Stronger demand will be underpinned by an improving
labour market, low funding rates, better financial conditions and pent-up demand.

Eurozone GDP growth has slowed in H2 2010 – in line with expectations – as some of
the temporary stimuli from the inventory cycle and fiscal policy have waned. Growth has
been very unevenly distributed across the eurozone Business confidence has risen to high
levels in Germany and France, which has  nourished expectations that the eurozone is
pulling out of its slowdown and that the debt crisis will not limit growth. Tighter fiscal
policies will, however, tend to dampen growth next year, though the foundation for positive GDP growth in 2011 remains in place.

Core inflation  in the US should remain very low at below 1% throughout 2011 – to the
continuing consternation of the Federal Reserve. Inflationary pressures are also limited in
Europe, with  inflation  rates set to remain in the  1.5-2.0% range in 2011. The  inflation
outlook will likely begin to trouble the ECB as we move into H2 2011.

Central banks and bond yields 
The Fed’s statement following  the  December  FOMC  meeting was largely unchanged
from November, indicating  a continued dovish  policy approach despite the recent improvement in data. The Fed is expected to continue its Treasury buyback programme.

However, given the prospect of stronger growth, we do not expect any further announcements of Fed buybacks. On the other hand, it will be some considerable time yet before
unemployment and inflation developments might be supportive of effective tightening.
We still expect the Fed to begin hiking rates at the end of H1 12. The market is pricing in
hikes as early as the start of 2012, but this is too aggressive, we believe.

We have raised our forecast of US 10Y Treasury yields for the entire forecast period.
With the recent increase in yields, bond markets are already pricing in our expectation of
strong GDP growth in 2011. As the sell-off looks a bit overdone in the short term, we see
room for a modest decline in yields from current levels over the coming months, but we
expect long bond yields to rebound on a 6M-12 horizon to their current levels. Our forecast of US  10Y bond yields is below  forward rates for all forecast horizons up to  12
months. 2Y yields are also expected to decline over the coming three months and then to
rebound on a 6M-12M horizon. Our forecast of 2Y yields is below forward rates for the
entire forecast period.

The  ECB has  announced an extension of full allotment at liquidity auctions  until 12
April. Thereafter, the ECB should gradually normalise liquidity conditions in 2011. We
expect the ECB to start hiking rates in Q4 11.

German long bond yields have moved upwards in recent months, although the increase
has not  fully matched that in US markets. We have raised our forecast of German 10Y
government bond yields, although German 10Y yields – like their US counterparts – are
expected to trade slightly lower on a  3M horizon. On 6M and 12M horizons, though,
German yields should move higher as US yields increase and ECB rate hikes draw closer.

Our German yield forecast is below the forward market for all forecast horizons up to 12
months. We expect 2Y yields to decline slightly over the coming three-month period. On
a 6M-12 month horizon, the increase in  2Y yields should resume as the  ECB  exits it
unconventional policy measures and rate hikes draw closer.  Our 2Y yield forecast is
below the forward market for all forecast horizons.

Yield curves
We expect the 2Y-10Y yield curves in both Europe and the US to flatten slightly. Not
least, a sharp steepening of the US Treasury curve has created good potential for flatter
curves.  Particularly European 2Y yields are set to move gradually higher as  rate hikes
move closer and the economic recovery continues in 2011.

Country spreads
European bonds are generally expected to underperform  their US  counterparts over the
coming year, as US yields have increased more than European yields and the ECB is set
to launch its hiking cycle earlier than the Fed.

Danish yields
Danish bond yields should continue to move in tandem with German yields. We expect
the 10Y yield spread to Germany to remain unchanged at 10bp in 2011. The official
policy rate spread between Denmark and the eurozone is still at a record-low 5bp and
should remain unchanged over the coming year. Meanwhile, the Danish central bank,
Nationalbanken, should continue hiking its certificates of deposit rate as European money
markets normalise.

We expect CIBOR rates to move upwards over the coming 12 months as the ECB exits its
unconventional policy measures and gets ready to launch its hiking cycle.
Interest rates on 1Y (F1) interest-reset loans should increase gradually next year as money
market rates move higher.