Invesco Canada blog

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Rob Waldner | April 11, 2018

Interest rate outlook: Weaker-than-expected data lower US inflation expectations

Invesco Fixed Income shares its views on rates around the world

Canada: Neutral. Signs of slowing economic growth and uncertainty over U.S. trade policy continue to limit the ability of the Bank of Canada to tighten monetary policy quickly. Even employment growth, which outperformed in the fourth quarter, has been flat over the last three months. The Canadian 10-year yield peaked at 2.37% in February, and we do not expect it to revisit that level in the near term.1

U.S.: Neutral. Compared to the start of the year, short-term growth and inflation expectations are lower due to weaker-than-expected consumption data and easing inflation. We expect the U.S. Federal Reserve to hike rates twice more this year following its latest increase of 25 basis points in March, with a risk of an additional hike if inflation accelerates (not our base case). We continue to expect above-trend growth at around 2.75% and inflation to remain moderate at around 1.9%. We expect lower inflation expectations to reduce Treasury market volatility in the near term.

Europe: Underweight. European Central Bank (ECB) President Mario Draghi maintained a dovish tone after the March ECB meeting while expressing greater confidence in the growth outlook. Language around quantitative easing was tweaked to remove the easing bias. Draghi noted that the ECB would be patient in making changes to monetary policy given the lack of convincing signs of a sustained upward move in inflation. We now think that ECB asset purchases are likely to extend into December 2018, with the tapering decision to be announced in June or July.

China: Overweight. We continue to see attractive opportunities in onshore government bonds, and with new asset management rules and liquidity management guidance in place, we expect demand for Chinese government bonds to pick up. Markets are still waiting for direction following the announcement of the new People’s Bank of China (PBOC) governor and the potential for further financial regulatory measures. In our view, regulatory tightening has pressured non-bank financial institutions, and we see limited room for the PBOC to tighten liquidity further. In addition, lowering financing costs in the real economy has remained a major task assigned by top policy makers, all suggesting less upward pressure on yields in the near term.

Japan: Neutral. There is increased speculation that the Bank of Japan (BOJ) will tighten policy soon. However, we maintain that policy will likely remain unchanged in 2018. Inflation is running below the BOJ’s 2% inflation target,2 and due to recent yen appreciation it is unlikely that it will meet the target in the near term. The outcome of recent wage negotiations was an average increase below the 3% goal set by Prime Minister Shinzo Abe, but it should still support increased consumption. A land sale scandal involving senior members of the government, including Abe, has the potential to escalate, and we are watching it closely. We expect 10-year Japanese government bond yields to remain range-bound over the next month between 0% and 0.1%.

UK: Neutral. The UK economy continues to be negatively impacted by uncertainty surrounding Brexit. Most market forecasts for 2018 to 2022 point to growth in gross domestic product (GDP) below 1.5%. Lower Purchasing Managers’ Index (PMI) numbers, negative real wages and businesses planning to relocate to the eurozone due to Brexit make us less than optimistic about growth. In the services industry (which dominates the UK economy), some restaurant chains have recently announced closures caused by expensive imports and upward pressure on wages due to worker shortages. Inflation remains above the 2% target but is likely to decrease later this year.3 We expect the Bank of England to hike rates in May, but additional hikes in 2018 will likely depend on Brexit discussions and economic performance over the next few months. Gilt yields are likely to continue trending down over the near term.

Australia: Neutral. The Reserve Bank of Australia (RBA) held rates steady again at its March meeting and stressed “patience” in its statement. The only notable change was the opinion that the rate of wage growth appears to have troughed. Fourth-quarter GDP was slightly below expectations (due to a decline in exports) but was still relatively strong. Despite a vibrant economy and optimistic business surveys, the RBA remains concerned about the consumer and lack of wage growth. We expect the RBA to remain on hold for the foreseeable future.

India: Neutral. Government bond yields have risen about 125 basis points since the beginning of August 2017 after several months of upside inflation surprises. However, yields seem to have stabilized after the last two softer inflation reports.4 We expect consumer price inflation to remain firm from April to June before reverting to around 4.5% in the second half of the year. The recent banking sector fraud involving Punjab National Bank and several other state-owned banks will likely result in slower credit growth, which could also drag down inflation. We are watching for confirmation of slowing credit growth and softer inflation, which could lead us to move overweight rates.

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1 Source: Bloomberg L.P., Feb. 1, 2018 to Feb. 28, 2018.
2 Source: Bank of Japan, March 22, 2018.
3 Source: Bank of England, March 22, 2018.
4 Source: Bloomberg L.P., Aug. 1, 2017 to March 22, 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.

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 Purchasing Managers’ Index (PMI), a commonly cited indicator of the manufacturing sectors’ economic health, is calculated by Markit Economics for the UK.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified investments.

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