Fixed Income

n Euroland, bond yields have been edging lower and the curve has been steepening over past 3-4 weeks. This largely reflects less concern about the inflation outlook and in turn reduced expectations for further ECB hikes this year. Currently, the market is pricing in around a 15% probability of another ECB hike this year. Given the deteriorating economic outlook and the slowdown in commodity prices, we judge the current pricing as being close to fair. Going forward, the risk is for more steepening and lower bond yields, but the size and speed of such a move will largely depend on ECB rhetoric. Next week's ECB meeting (Thursday) will be the key event in European bond markets. We expect the central bank to keep rates unchanged at 4.25% and to re-iterate inflation concerns but also give a nod to the deteriorating economic data (see Euroland section). With the bulk of the hike expectations already removed, we do not expect the meeting to prompt any major reaction in the market. Hence, as long as the ECB sticks to its inflation-fighting rhetoric, any fur-ther declines in bond yields will occur at a slower pace going forward.

While very volatile, the US bond market has basically been moving sideways in July - and this despite Ber-nanke's reinstatement of significant downside growth risks in his congressional testimony in mid-July. On balance, the economic data have been slightly better than expected, although the outlook for H2 remains pretty negative, as the tax rebate boost to consumers will be fading soon. Moreover, several hawkish speeches from regional Fed governors have helped keep alive market fears of an early monetary policy re-versal. Finally, supply concerns in the Treasuries market amidst a deteriorating US budget outlook have kept the curve buoyant - particularly at the long end. We still believe that the current market pricing of a 60% probability of a hike this year is too aggressive. We expect the Fed to keep the policy rate unchanged at 2.00% at Tuesday's FOMC meeting and the statement to closely resemble the message from Bernanke's testimony, ie, that the Fed is firmly on hold. On balance, we think such an outcome could produce some bull-ish steepening in the US Treasuries curve.

Aside from the ECB and Fed meetings, the rate decision from the Bank of England (Thursday) will also at-tract attention in the fixed income market. We look for an unchanged policy rate of 5.00%, but continue to expect monetary easing further down the road.

Full Report in PDF

Danske Bank
http://www.danskebank.com/danskeresearch

Disclaimer

This publication has been prepared by Danske Markets for information purposes only. It is not an offer or solicitation of any offer to purchase or sell any financial instrument. Whilst reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and no liability is accepted for any loss arising from reliance on it. Danske Bank, its affiliates or staff, may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives), of any issuer mentioned herein. Danske Markets' research analysts are not permitted to invest in securities under coverage in their research sector. This publication is not intended for private customers in the UK or any person in the US. Danske Markets is a division of Danske Bank A/S, which is regulated by FSA for the conduct of designated investment business in the UK and is a member of the London Stock Exchange.