Invesco Canada blog

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Rob Waldner | July 6, 2018

Interest rate outlook: U.S. inflation should peak this summer

U.S. growth remains strong, accelerating in the second quarter versus the first quarter’s lackluster 2.2% performance.1 We expect 2018 growth of around 2.8%, with strong contributions from capital expenditures and consumption. Core inflation continues to be benign, and we see it peaking in the next two months at around 2.2%. After that, softer rental and service costs should drive it back below 2%. In our view, the U.S. Federal Reserve will hike one more time this year before pausing in response to declining inflation. Strong growth and lower-than-expected inflation point to a 10-year Treasury yield of around 3%. However, supply dynamics will likely begin to shift in the third quarter as the Treasury begins to issue more long-term debt. This may pressure the Treasury yield curve steeper.

Europe

Underweight: The European Central Bank (ECB) delivered another dovish taper announcement in June. The long-awaited end to quantitative easing was announced for December 2018, to follow a three-month period of reduced bond purchases totaling 15 billion euros per month. But ECB President Mario Draghi surprised the market with firmer forward guidance on interest rates, suggesting no rate hikes through the summer of 2019. The ECB’s downgrade of its 2018 growth projection to 2.1% (from 2.4%) was coupled with an acknowledgement that the recent period of slower growth may last longer than expected.2 This has weighed on German bund yields, steepened the long end of the German yield curve and weakened the euro. However, we think the downside risk to yields is limited and we remain underweight duration.

China

Overweight: We continue to see attractive opportunities in onshore government bonds in the medium term, although range-bound trading is expected in the near term. With new asset management rules in place, demand for Chinese government bonds and policy bank bonds should increase, and we have already seen a boost in foreign investment in China’s onshore bond market ahead of its planned inclusion in the Bloomberg Barclays Global Aggregate Bond Index. Regulatory tightening has pressured non-bank financial institutions to reduce lending, and we see limited room for the People’s Bank of China to tighten liquidity further. In addition, lowering the cost of financing in the real economy remains a major objective of top policymakers, suggesting less upward pressure on yields in the near term.

Japan

Neutral: The Bank of Japan kept policy unchanged at its June meeting; however, it downgraded its inflation assessment. With a consumption tax hike planned for 2019 (which could have a negative impact on the economy), and consumers remaining hesitant to spend despite increased wages, it is difficult to see the bank tightening in 2018. Therefore, the 10-year Japanese government bond yield is likely to remain anchored in the 0.0% to 0.1% range.

UK

Neutral: Uncertainty surrounding Brexit appears to be negatively impacting the UK economy. The picture is unlikely to become clearer until late 2018 or early 2019, which could dampen consumer and business confidence in the meantime. The UK government is struggling to agree on a negotiating stance, and political infighting could result in a vote of no confidence in the prime minister, if not the government itself. The Bank of England pulled back from hiking rates in May and may be reluctant to hike in August given the ongoing political uncertainty, weak economy and progress toward its inflation target.

Canada

Neutral: Trade headlines continue to dominate the news. So far, nothing has come of the North American Free Trade Agreement negotiations, but that could change abruptly. First-quarter gross domestic product (GDP) disappointed compared to expectations, but components of second-quarter GDP showed signs of a rebound. Wages have strengthened somewhat, partly due to recent increases in the minimum wage. Despite some headwinds, the Bank of Canada looks likely to hike the overnight rate again in July. Our outlook for interest rates is positive, as the 10-year Canadian government bond yield should remain below its recent high of 2.52%.3

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1 Source: Bureau of Economic Analysis, May 30, 2018
2 Source: European Central Bank, June 14, 2018
3 Source: Bloomberg L.P., May 17, 2018

Important information

Quantitative easing (QE) is a monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective.

Tapering is the gradual winding down of central bank activities that aimed to reverse poor economic conditions.

Gross domestic product is a broad indicator of a region’s economic activity, measuring the monetary value of all the finished goods and services produced in that region over a specified period of time.

The Bloomberg Barclays Global Aggregate Bond Index is an unmanaged index considered representative of the global investment-grade, fixed-rate bond market.

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