February 2015 - Daiwa Capital Markets

Economic Research Team
(+44 20 7597 8326)
18 February 2015
Fixed Income Markets: Interest and exchange rate outlook – February 2015
End period
Fed Funds
0.25-0.50 0.50-0.75
ECB Refi
BoE Bank
10Y Bund
10Y Gilt
According to the advance estimate, which looks likely to be revised down, US GDP growth moderated in Q414 to 2.6%Q/Q ann. from 5%Q/Q ann. in Q3 reflecting softer capital spending and
a notable negative contribution from net trade. But private consumption jumped more than 4%Q/Q ann., almost double the average of the past four years, and conditions seem in place for
GDP growth rates of 2½-3%Q/Q ann. to be sustained through 2015. Indeed, significant positive momentum persists in the labour market, with the unemployment rate down to 5.7% in January
and non-farm payrolls up on average over the past three months by more than 330k, the firmest since the late ‘90s. At its January meeting, the FOMC gave a more upbeat economic
assessment. And despite lower market measures of inflation expectations, the Committee continued to expect inflation to rise gradually toward 2% as the labour market continues to improve
and transitory effects of lower energy prices dissipate. The FOMC also maintained its judgement that it ‘can be patient in beginning to normalise the stance of monetary policy’ and added
‘international developments’ to factors that might delay the timing of the first rate hike. But we continue to think that this will take place in June 2015, with rates rising gradually thereafter.
Having fallen back into technical recession in Q2 and Q3, Japanese GDP returned to growth in Q4, although the rate of 0.6%Q/Q was softer than expected. Recent surveys point to a rosier
outlook at the start of 2015. And modest fiscal stimulus, postponement of the next consumption tax hike (from October 2015 to April 2017), and ongoing BoJ asset purchases should help
sustain the recovery over coming quarters too. In contrast, the inflation outlook has deteriorated over recent months, with the headline rate of CPI (excluding the consumption tax effect) falling
to an 18-month low of 0.3%Y/Y in December, down more than 1ppt since the summer. And we expect the BoJ’s preferred core CPI measure (excluding prices of fresh foods) to fall briefly into
negative territory by the summer. With the BoJ currently increasing its JGB holdings at an annual rate of ¥80trn, which will increase its share of the JGB market to about one third by end-FY15,
we see any additional near-term expansion of QQE unlikely. Instead, we simply expect the current rate of asset purchases to be maintained at least until FY17 when the consumption tax is
due to be hiked again.
The ECB’s QE announcement exceeded expectations. Monthly purchases of €45bn of euro area sovereign, agency and EU institution bonds will commence from March and are intended to
be carried out until at least September 2016. Along with the existing programme of covered bond and ABS purchases, the ECB thus intends to expand its balance sheet by more than €1trn by
end-Q316. With buying to be conducted at least until the ECB judges that inflation has moved back to a path consistent with achieving its target (below but close to 2%) over the forecast
horizon, the programme is potentially open-ended. Inflation continues its downward trend, declining to the series low of -0.6%Y/Y in January with core inflation also at an all-time low of
0.6%Y/Y. And we expect inflation to fall further over the near term and remain below zero until Q415. Meanwhile, euro area GDP grew a firmer-than-expected 0.3%Q/Q in Q414, led by Spain
and Germany (both 0.7%) but with France and Italy still weak. Economic surveys indicate a similar performance in Q115. While the weaker euro and lower oil price will give an extra boost, and
on balance we expect an agreement eventually to be reached to keep Greece in the euro, we expect GDP growth to remain moderate over coming quarters.
While UK GDP slowed more than expected in Q414, growth of 0.5%Q/Q still marked the eighth consecutive quarter of expansion, to leave output 2.7% higher than a year earlier, the fastest
pace for seven years. The most significant development over recent months, however, relates to the inflation outlook. Headline CPI fell to just 0.3%Y/Y in January, the lowest rate of inflation
for more than half a century, on the back of the sharp decline in energy prices. And it seems bound to fall further – possibly to negative territory – over coming months. But excluding energy
prices, the core measure of CPI is expected to remain above 1%Y/Y. Moreover, the unemployment rate has fallen faster than expected, to 5.7% in the three months to December, the lowest
since 2008. And there are signs that regular wage growth is finally picking up too, with growth of 1.8%3M/Y in November the firmest for more than two years. While the weak near-term
inflation outlook saw the two members previously advocating a rate hike rejoin the majority in voting for no change in January, the BoE’s latest Inflation Report made clear that the next move in
rates is still likely to be up. Nevertheless, given the weak near-term outlook for CPI, the majority will feel comfortable leaving Bank Rate unchanged at 0.50% for the remainder of 2015.
10Y UST yields maintained their broad downward trend through to end-January, briefly moving below 1.65% just after the FOMC’s last meeting. But with the oil price having moved higher
since the start of February, Treasury yields have largely reversed the decline recorded in January, with short-dated yields moving back close to multi-year highs in anticipation of the first hike
in the FFR this cycle. Nevertheless, the likelihood that the FFR will stay below ‘normal’ levels for a long time to come, a softening of the US (and global) economy’s medium-term growth
potential, and persistent solid global demand for dollar assets should ensure that the upwards trend in 10Y UST yields remains gradual and limited.
With the BoJ having stepped up the rate of its purchases, JGB yields fell significantly across the curve up to the middle of January, with yields across the curve at record lows. But concerns
about the liquidity in the JGB market, uncertainty about the impact of the ECB’s launch of QE and the approaching first interest rate hike in the US saw JGB yields move notable higher over
recent weeks. While market volatility looks set to remain to the fore, with the BoJ’s purchases set to more than offset new issuance, we expect the JGBs to grind lower over coming months.
Anticipation and subsequent confirmation of ECB QE saw 10Y Bund yields continue their downward march to end January at an all-time low close to 30bps. While they picked up again in
February, ECB purchases from March onwards imply very high demand relative to supply. Indeed, we suspect the ECB will struggle to reach its purchase target. Therefore, we expect Bund
yields to grind lower over coming quarters.
10Y Gilt yields fell to a record low, of 1.33%, at the end of January. But, as for USTs, Gilt yields have since risen sharply, back above 1.80% in recent days. While yields are likely in due course
to rise further, with the Fed to tighten policy before the BoE we see scope for 10Y Gilt yields to remain below their UST counterparts over coming quarters.
In the immediate aftermath of the ECB’s sovereign QE announcement, the euro slipped to a more than 10-year low through €1.12/$. And with the Fed still moving towards a rate hike in 2015
while euro area rates are set to remain exceptionally low, further steady euro depreciation appears likely.
Having depreciated almost 7% against the dollar in the six weeks after the announcement of QQE2, the yen has since moved broadly sideways. While the possible adverse effects of yen
weakness having become a topic of political debate in Japan, we expect further gradual depreciation against the dollar as the Fed moves to tighten and the BoJ continues with QQE2.
Much of the notable post-QQE yen depreciation against the euro, to a six-year high of ¥150/€, was reversed at the start of 2015 as expectations of ECB QE mounted. And while the yen has
subsequently depreciated slightly again, we see modest appreciation of the yen against the euro likely as differentials between euro- and yen-denominated interest rates widen further.
Sterling fell sharply against the dollar at the start of the year, slipping below $1.50 for the first time since mid-2013. While sterling has subsequently appreciated, with the Fed on track to raise
rates before the BoE sterling seems likely to lose ground against the dollar over the near term.
With economic conditions in the UK still significantly more favourable than in the euro area, sterling has appreciated sharply against the euro since the start of the year, rising to €1.35 for the
first time since 2007. And the relatively firm economic outlook in the UK means that sterling should gain further modest ground against the euro over coming quarters.
Figures in parentheses are previous forecasts. Source: Bloomberg and Daiwa Capital Markets Europe Ltd.
Fixed Income Markets: Interest and exchange rate outlook – February 2015
18 February 2015
Economic Research
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