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Tuesday, 16th April 2024
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All eyes on the US, which holds the key Back  
Interest rates and bonds
Dermot O’Brien, Head of Economic Research, NCB


US Fed funds 5.50%
10 Year Bond 5.00%
ECB repo 4.75%
10 Year bund 4.65%
BOE base 5.75%
10 Year Gilt 4.60%
IRL/GER 10 year spread: 15bps

Fourth Quarter Outcome: Monetary policy decisions panned out as we expected but bond markets were considerably more buoyant. From early-November, with equity markets coming under renewed pressure and the view growing that the US economic slowdown might result in a hard rather than a soft landing, bonds rallied with yield curves steepening as the possibility of rate cuts in the US, particularly, was priced in. The Fed validated the change in sentiment by moving to an easing bias before Christmas and cutting rates an aggressive 50bps in the New Year. Though the European economy looks less vulnerable than the US, bonds rallied as any possibility of higher ECB rates disappeared and some chance of lower rates emerged.

Q1 2001 Forecast: At this stage, US markets have priced in substantial interest rate cuts with 2-year yields about 120 basis points below the new Fed funds target. Moreover, the US yield curve is still relatively flat. In these circumstances, it is likely to be difficult for the US treasuries market to make much more headway without a further material deterioration in the economic outlook. For this reason, US bonds seem likely to mark time more than anything else in Ql.

Though the Euroland economy has cooled a little, the downside is protected to a degree by relatively low interest rates and the large tax cuts planned in Germany, France and Italy. The ECB will be reluctant to ease policy against that background and rates should be held steady during Q1. Thereafter, with the likelihood of further recovery in the euro putting some pressure on Euroland exports, prospects of a rate cut should improve.

Anticipation of this in Ql should allow Euroland bonds to reverse some of the differential narrowing relative to the US that has been seen lately.

In the UK, there may be more of a possibility that rates will be cut in Q1 as inflation risks recede further and concern about the backwash from a US slowdown is paid more attention to by the MPC. Though the UK was a poor performer in the recent rally, the prospect of lower rates should help gilts make more progress in the period ahead. Given the very positive relative funding position in Ireland we remain bullish of spread narrowing and look for the Irish/German 10-year differential to move towards 15 basis points in the coming quarter.

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