FYI | Dec 04 2007
By Chris Shaw
The market is pricing in a cut to US interest rates later this month and in the view of Danske Bank it is correct to do so but it should also be pricing in further cuts and an increased probability of a US recession.
The group expects the US Federal Reserve will actually cut rates by a total of 0.75% as it deals with the slowing economy and the fact a number of factors are impacting on the US economy’s health at the same time. These include tighter credit standards, rising oil and food prices and the ongoing correction in the housing sector.
As a result the group’s view is the US economy faces significant headwinds in the coming 3-6 months, though by the middle of 2008 the picture should begin to brighten and growth should show signs of trending higher.
The US slowdown is also impacting on the growth outlook in the European Union in the shorter-term, as Danske Bank notes the weaker US dollar means a stronger euro and this is acting as a handbrake on the European economy generally.
Again though, as the second half of 2008 rolls around the group expects signs of a pick-up as European investors are likely to be heartened by signs of improvement in the US economy.
Extending this view through to government bonds leads Danske to forecast lower yields in the US in the coming quarter, while the EU headwinds are likely to see investors price in one or two rate cuts and this will also impact on yields on euro denominated investments.
Assuming the US recovers as it expects Danske Bank then sees US yields recovering later next year and this should also drive euro bond yields higher, meaning the yield curves in both regions are likely to become steeper on a 3-6 month view but on a 6-12 month view should begin to flatten out.
In relative terms the group expects the US to outperform the EU in the short-term as interest rates are clearly heading lower in the US economy but the European Central Bank (ECB) remains hawkish with respect to inflation, so limiting any downside in terms of interest rates. Medium-term the opposite is likely as it should only take around six months for recession fears to fade in the US economy.
