Recent inflation data are likely to keep the Federal Reserve (Fed) on track to hike interest rates in December. Stable inflation (despite strong growth) should continue to support slow monetary policy normalization going forward. As we expected, price pressures from recent hurricanes are beginning to feed through to inflation data. Uncertainty around the true inflation trend will likely cap US Treasury yields in the near term, despite upward pressure from policy normalization.
European growth continues to surprise to the upside while inflation remains muted. The European Central Bank’s commitment to maintain its asset purchase program and not increase interest rates until well past the end of the program has kept the short end of the yield curve anchored. At this time, no rate hikes are priced in by the market before 2019. Long (10-year) German bund yields have traded in the 35 to 40 basis point range, while peripheral government bond yields have traded tighter.1
Longer-term onshore government bond yields rose relative to short-term yields in the first half of November as higher-than-expected inflation and concerns over additional financial regulations shifted market sentiment. President Xi Jinping’s speech at the 19th Party Congress pointed to a quality-focused growth strategy and additional emphasis on strengthening financial regulation. In our view, this suggests slower credit growth and a lower rate of economic growth going forward. This should support the performance of Chinese onshore rates in 2018.
Japan is experiencing its longest growth streak in 16 years, helped to a large degree by a pickup in global demand.2 We believe external demand will remain robust as we head into 2018. Domestic consumption should remain positive also, helped somewhat by a government tax initiative that incentivizes companies to pay higher wages to its staff. Headline inflation has moved higher over the past few months, however, as oil prices have been elevated and the yen has traded at depressed levels (on a real effective exchange rate basis). Therefore, additional upside appears limited. We expect the Bank of Japan to keep policy unchanged over the coming months and for 10-year government bond yields to range between 0% and 0.1% through year-end.
The Bank of England hiked rates by 25 basis points in November, in line with market expectations.3 The comments that accompanied the decision suggested that the pace of future increases would be relatively slow (two more hikes over the next three years). Given the uncertainty surrounding Brexit discussions, that would appear to be reasonable. It is difficult, however, not to see additional hikes being priced in as we make our way toward the end of Brexit discussions. These discussions are likely to prove fractious over the next six months, but as the endgame becomes clearer (our base case is a soft Brexit or no Brexit), we believe the market will likely price in additional hikes. Our positioning remains neutral at this time, but we are looking for an opportunity to move underweight.
The Bank of Canada has backed away from the rate-hiking cycle that began in July as economic growth has slowed from the rapid pace seen earlier this year. Despite strong employment growth, the next rate hike is now not expected until March 2018. Inflation remains low and should allow long-term interest rates to consolidate at current or lower levels, in our view.
The Reserve Bank of Australia (RBA) remained neutral in November, leaving the interest rate at 1.50%.4 The statement remained balanced with a positive business outlook offset by concern over weak household consumption. The unemployment rate has fallen, but wage inflation continues to be nonexistent. High consumer debt and low wage growth should continue to constrain consumer spending. We expect low overall inflation and a strong housing market to keep the RBA on hold. We remain neutral on Australian rates.
Government bond yields have risen significantly since August after an upside inflation surprise. We believe that inflation will likely stabilize at around 4% to 4.25%, up from its current level of 3.6%, but remain within the Reserve Bank of India’s target range.5 The combination of a hawkish central bank, high real interest rates by historical standards and a benign growth environment has made yields potentially attractive, in our view. However, we would like to see inflation stabilize.
Rob Waldner, Chief Strategist; James Ong, Senior Macro Strategist; Noelle Corum, Associate Portfolio Manager; Reine Bitar, Macro Analyst; Yi Hu, Senior Analyst; Sean Connery, Portfolio Manager; Brian Schneider, Head of North American Rates Portfolio Management; Alex Schwiersch, Portfolio Manager; Scott Case, Portfolio Manager; Amritpal Sidhu, Quantitative Analyst
1 Source: Bloomberg L.P., Nov. 15, 2017
2 Source: Cabinet Office, Government of Japan, Aug. 14, 2017
3 Source: Bank of England, Nov. 15, 2017
4 Source: Reserve Bank of Australia, Nov. 7, 2017
5 Source: Bloomberg, Reserve Bank of India, Nov. 13, 2017
A basis point is one hundredth of a percentage point.
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.
The iShares Barclays 7-10 Year Treasury Bond Fund (IEF) closed at $105.91 on Friday, down $-0.08 (-0.08%). Year-to-date, IEF has gained 2.10%, versus a 19.88% rise in the benchmark S&P 500 index during the same period.
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