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All eyes on the US, which holds the key Back  
Interest rates and bonds
Oliver Mangan, Chief Bond Economist, Primary Dealer Unit, AIB Group Treasury.

US Fed Funds: 5.5%
10 year bond: 4.75%
ECB Repo: 4.75%
10 year bund: 4.5%
BOE base rate: 6.0%
10 Year Gilt: 4.5%
IRL/GER 10 year yield spread: +20bps

Looking Back: Our forecasts for official interest rates were spot on with the Fed and BoE leaving rates unchanged, while the ECB increased rates by 25bps. On this basis, we did not anticipate any great change in bond markets but this proved incorrect as yields fell substantially across all markets. A marked slowdown in the pace of economic activity, most notably in the US, excited expectations that central banks would cut interest rates in 2001. The unexpected sharp drop in oil prices during Q4 2000 was also seen as eliminating an inflationary threat, thereby removing a barrier to an easing of monetary policy in 2001.

Looking Forward: Already in early January, the Fed has cut US interest rates by 50bps. Leading indicators of economic activity suggest that the US economy will weaken further in the coming months. Thus, we expect two further 25bps rate cuts in Q1 taking the Fed funds rate down to 5.5%. We are not convinced that the BoE or ECB will reduce rates in Q1 as activity in both economies remains more robust than in the US. Our forecast is for unchanged rates in both cases, although the balance of risk is tilted towards easing.

Bond yields in the US and Europe have fallen well below official interest rates in anticipation of monetary easing. Thus, we have probably seen most of the bond market rally at this stage, especially if Fed easing prompts an equity market recovery. Nonetheless, US rate cuts imply yields are likely to fall further in Q1, especially with economic data expected to remain on the weak side. Meanwhile, the ten year Irish-German yield spread may edge down to around 20bps given the lack of supply here.

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