What Will The Fed Do If Inflation Declines?

Share This Article
May 16, 2018 6:30am NASDAQ:TLT

From Invesco: Falling US inflation may become a Fed concern by late 2018. Invesco Fixed Income shares its views on rates around the world.


Neutral. Inflation trends are showing no signs of a significant pickup, and economic data over the coming months should support a Federal Reserve (Fed) rate hike in June (currently expected by the market). We think slowing inflation will become a concern for the Fed later in the year, especially as the housing component slows. Over the longer term, we believe risk/reward dynamics favor US Treasuries, especially if geopolitical uncertainty begins to increase. However, with the market correction pushing yields higher in April, we remain neutral on US rates in the near term.


Underweight. Eurozone economic data and several survey indicators have weakened since the start of the year. However, we see this as normalization from extremely strong levels and do not expect a significant slowdown in growth. Domestic fundamentals such as capital expenditures and hiring intentions still indicate that the business cycle has room to run. The European Central Bank (ECB) sees the main risk from global trade tensions coming from a potential decrease in confidence, which could delay capital spending plans. Therefore, we will be watching confidence indicators very closely in the coming months. We think ECB asset purchases will likely extend into December 2018 and expect the tapering decision to be announced in June or July.


Overweight. We continue to see attractive opportunities in onshore Chinese government bonds, and with new asset management rules in place, we expect demand for Chinese government bonds to pick up. In our view, regulatory tightening has pressured non-bank financial institutions, and this leaves limited room for the central bank to tighten liquidity further. In addition, lowering the cost of financing in the real economy remains a major task assigned by top policymakers, all suggesting less upward pressure on yields in the near term.


Neutral. The Japanese economy continues to perform well. Wage increases resulting from the recent negotiations between unions and employers should help consumption. Export demand remains dependent on the well-being of the global economy. We continue to expect solid growth, but an escalation in trade war rhetoric could dampen those expectations. Inflation remains well below the Bank of Japan’s (BOJ) 2% inflation target.1 Consequently, we believe the BOJ is likely to remain accommodative — despite increasing calls to change direction. Over the next month, we expect 10-year Japanese government bond yields to remain range-bound between 0% and 0.1%.

United Kingdom:

Neutral. Since the beginning of 2017, the UK economy has underperformed compared to its European Union (EU) counterparts, mostly due to the uncertainty surrounding Brexit. Forward-looking Purchasing Manager’s Index data suggest a continuation of this trend. The UK is due to leave the EU in March 2019, and negotiators from both sides will try to strike a deal regarding their ongoing trading relationship in the coming months. However, we think it is unlikely that a final deal will be reached by the official departure date, as it would need to be ratified by all 28 countries. Calls for an extension to the UK’s EU membership may increase, and a vote of “no confidence” in the UK government cannot be ruled out. At its May meeting, the Bank of England (BOE) kept policy unchanged, but revised down growth forecasts for 2018 and said that inflation was cooling faster than previously predicted. The central bank also toned down its language on rate hikes, saying these would be “limited” going forward. The market continues to expect a rate hike in 2018, but against the backdrop of challenging Brexit discussions, we think confidence could diminish significantly over the weeks ahead.


Neutral. Economic data have been mixed since the Bank of Canada increased the overnight rate 25 basis points in January.2 Employment growth remains positive and consumer price inflation has been firm. However, retail sales and exports have been soft, and housing turnover has fallen since housing policy changes last year caused turnover to be concentrated in the fourth quarter of 2017. The Canadian 10-year yield has traded between 2.08% and 2.38% for most of the year.3


Neutral. The Reserve Bank of Australia (RBA) held rates steady again at its April meeting. The subsequent statement continued to express optimism for the future while stressing “patience.” Within this statement, the RBA expressed some concern for financial conditions and noted that further global monetary tightening was expected. Retail sales rebounded in February, but consumer and business confidence surveys have fallen recently, though they remain relatively optimistic. The labor market remains strong, but most new jobs have come from lower-paying sectors — keeping wage inflation lower than desired. The RBA is likely to remain on hold for the foreseeable future, especially as long as inflation and wage growth remain low.


Neutral. We like current yield levels from a valuation perspective, and have observed a rally from the highs in early March on the back of lower inflation prints, a favorable government borrowing calendar and the Reserve Bank of India relaxing the mark-to-market rule for government securities. Going forward, we see inflation as the key uncertainty and the main reason for our neutral stance on Indian interest rates. Inflation averaged about 4.6% in the first quarter of the year, 4 driven by moderation in food prices, while core inflation remained at 5.4% in March. We still expect inflation to average around 4.5% in the second half of 2018, but upward pressure could come from higher crude prices or the government setting higher minimum support prices for crops.

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; Scott Case, Portfolio Manager; Amritpal Sidhu, Quantitative Analyst

Read Invesco’s currency outlook.

1 Source: Bank of Japan, Jan. 22, 2013

2 Source: Bank of Canada, Jan. 17, 2018

3 Source: Bloomberg, L.P., Jan. 1, 2018 to April 18, 2018

4 Source: Bloomberg, L.P., Jan. 1, 2018 to March 31, 2018

Important information

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

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.

This article is brought to you courtesy of Invesco.

Read Next

Get Free Updates

Join over 50,000 investors who get the latest news from ETFDailyNews.com!

Most Popular

From Our Partners

Explore More from ETFDailyNews.com

Free Daily Newsletter

Get daily ETF insights from our market experts. Never miss another important market development again!

ETFDailyNews.com respects your privacy.

Best ETFs

We've rated and ranked nearly 2,000 ETFs and ETNs using our proprietary SMART Grade system.

View Top Rated ETFs

Best Categories

We've ranked dozens of ETF categories based on relative performance.

Best ETF Categories