Inflation moved higher in August after five months of negative surprises. This will likely give the Federal Reserve confidence to hike interest rates in December. Although Hurricanes Harvey and Irma could cloud economic data (making it difficult to interpret near-term results), we expect GDP growth to remain modestly above potential at around 2.2% in the coming months. Uncertainty over the inflation outlook is expected to keep a ceiling on US Treasury yields until longer-term inflation expectations pick up.
The European Central Bank (ECB) kept policy unchanged in September as expected, although ECB President Draghi sent mixed messages. While he suggested that interest rates will likely remain low and expressed concerns over the euro’s strength, he also hinted at a tapering decision. These comments were initially taken dovishly by the market, but recent data continue to point to solid growth ahead. We expect the ECB to announce tapering of its asset purchases in October, with a reduction from ?60 billion to ?40 billion initially, to take effect in January 2018.
Our positive stance on Chinese interest rates remains intact. In the first half of September, the central bank maintained relatively loose liquidity conditions, and long-term rates fell faster than short-term rates. Data showing weaker-than-expected August economic activity also supported bond prices. We expect tighter financial regulations and strengthened financial deleveraging efforts following the National Financial Work Conference to reduce risk appetite and slow broader credit growth. China’s stabilized exchange rate and higher bond yields compared with those of many overseas markets have also attracted foreign inflows.
The Japanese economy continues to perform well, helped by a pickup in Asian demand for Japanese exports. Prime Minister Abe has taken advantage of this upswing, rising approval ratings due to his handling of North Korean tensions and disarray in the main opposition party to call an early election expected on Oct. 22. This is well in advance of the 2018 year-end deadline. The Bank of Japan is likely to keep policy unchanged in the near term, particularly while other central banks are beginning to move toward tightening.
The minutes from September’s monetary policy meeting surprised many market participants, as a majority of committee members thought it would be appropriate to increase rates “over the coming months.” These comments will be scrutinized and multiple rate hikes will likely be priced into bond markets over the next 12-18 months. Brexit discussions are proving to be very challenging, not only between the European Union (EU) and the UK, but among UK politicians too. The potential for another election is increasing, in our view. With political outcomes so uncertain, we believe the Bank of England will merely seek to remove the emergency stimulus introduced after the EU referendum (25-basis-point cut) and then continue to assess conditions going forward.
The Bank of Canada (BoC) has hiked interest rates at two consecutive meetings, bringing the overnight benchmark rate to 1.00%.1 GDP growth and employment trends remain strong, while inflation has stayed below the BoC’s 2.0% target. The Canadian 10-year government bond yield has followed an upward trend after hitting its lows in the second quarter. We believe higher rates are likely.
The Reserve Bank of Australia (RBA) appears satisfied in keeping interest rates steady. Inflation, while improving, remains below the RBA’s target band. Labor data are improving, but the unemployment rate remains stubbornly high. The housing market is showing early signs of cooling, but remains relatively robust. This combination of low inflation, elevated unemployment and a strong housing market should keep the RBA on hold for the foreseeable future. We remain neutral on Australian interest rates.
Rob Waldner, Chief Strategist; James Ong, Senior Macro Strategist; Sean Connery, Portfolio Manager; Brian Schneider, Head of US Rates Portfolio Management; Scott Case, Portfolio Manager; Josef Portelli, Portfolio Manager; Yi Hu, Senior Credit Analyst; Ken Hu, CIO Asia Pacific; and Alex Schwiersch, Portfolio Manager
1 Source: Bank of Canada, Sept. 6, 2017
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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 iShares Barclays 7-10 Year Treasury Bond Fund (IEF) was unchanged in premarket trading Thursday. Year-to-date, IEF has gained 2.54%, versus a 14.44% rise in the benchmark S&P 500 index during the same period.
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