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Weekly Focus

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Focus shifting back to growth

Fri, Aug 8 2008, 14:35 GMT
by Danske Research Team

Danske Bank A/S

European bond markets have been remarkable this year as focus has shifted back and forth between fi-nancial crisis/weak growth and inflation. In the first quarter, focus was entirely on the acceleration in the financial crisis. The Fed was cutting rates aggressively and by the end of the first quarter the European market was pricing in 100bp of rate cuts from the ECB within a year.

In the second quarter, things swung dramatically the other way. Financial markets calmed while oil prices rose substantially. This shifted focus 180 degrees onto inflation, which suddenly became the main worry and prompted the ECB to announce a July hike. Within three months, the market went from pricing 100bp of cuts to 100bp of hikes within the next year.

Now we are in the third quarter, and the pendulum is shifting back toward a focus on growth. Oil and other commodity prices have retreated, dampening inflation worries. At the same time, the data in Euroland have weakened substantially - most notably in Germany, where indicators now suggest the economy could be on the brink of recession. This is what sparked the sudden shift in ECB rhetoric at the meeting on Thursday, when it softened its assessment of the growth outlook. The market, meanwhile, is now again pricing in a rate cut next year, and going forward we expect market focus to remain on the weak growth situation. In our view, rising unemployment and more soft surveys will result in the market pricing in more rate cuts - and hence bond yields should fall further and the yield curve should steepen again. This will be reflected in our revised yield forecast next week.

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Published on  Fri, Aug 8 2008, 14:42 GMT