Neutral. We expect increased Treasury supply to begin pressuring yields higher into year-end though fundamentals are supportive of lower yields. Inflation is likely to begin softening in the second half of 2018, and we believe US growth expectations have peaked. Volatility in US rates is likely to persist near-term as geopolitical concerns (such as in Europe, North Korea and the Chinese trade negotiations) remain in the spotlight. As a result, we are neutral on US rates.
Underweight. Political headlines out of Italy have been the main drivers of European government bond markets. A government coalition agreement between the two Italian populist parties (the Five Star Movement and Lega) initially took shape but then failed, leaving the prospect of new elections. German bund yields rallied (benefiting from a flight to quality) while European peripheral spreads underperformed aggressively, led by Italy. However, the two populist parties have finally managed to agree on forming a government with Giuseppe Conte as prime minister. This calmed market sentiment and saw Italy rally again. Meanwhile, there has been some stabilization in euro-area economic data after a weak first quarter. May headline inflation also picked up significantly to 1.9%1, primarily on the back of higher oil prices. We think European Central Bank (ECB) asset purchases will likely extend into December 2018 and expect the tapering decision to be announced in July.
Overweight. We continue to see attractive opportunities in onshore government bonds in the medium term, although range-bound trading is expected for now. With new asset management rules in place, demand for Chinese government bonds (especially shorter-term) should increase. In our view, regulatory tightening has pressured non-bank financial institutions, and we see limited room for the central bank to tighten liquidity further. In addition, lowering financing costs in the real economy remains a major policy objective, all suggesting less upward pressure on yields in the near term. Liquidity could tighten mid-year and we expect to see further reserve requirement ratio cuts by early in the third quarter.
Neutral. The Japanese economy recorded negative growth in the first quarter according to preliminary data. Weak consumption was one catalyst. While these prints can be revised, we believe future revisions will confirm that the economy has peaked for now. The recent wage negotiation round went relatively well, although there are very few signs that this positive news is putting meaningful upward pressure on inflation. In fact, the April headline and core measures of inflation both disappointed to the downside. Inflation is still below the Bank of Japan’s (BOJ) 2% inflation target.2 Therefore, in our view, the BOJ is likely to keep policy unchanged through 2018, and the 10-year Japanese government bond yield will likely continue to trade between 0.0% and 0.1%.
Neutral. The Bank of England kept rates on hold at its May meeting. While there is still the possibility of a hike later in the year, an escalation in Brexit uncertainty could create a difficult environment for tightening policy. The UK economy continues to disappoint, as consumers are reluctant to spend and inflation is declining. If these trends continue, market participants may price out the possibility of a 2018 hike completely. The Brexit issue has remained unresolved, but we maintain our base case that there will be a soft Brexit at worst. Any indication that the UK-European Union relationship will remain as is for an extended period (two to three years) would most likely prove positive in the shorter term, as it would bring about some certainty for both consumers and businesses.
Neutral. The most recent headline employment report was disappointing, but the underlying details were more positive. Wages are showing some signs of strength (partly due to recent increases in the minimum wage) and NAFTA negotiations are ongoing. Canada faces some headwinds due to the US corporate tax policy changes in 2017 that made Canada less competitive for companies versus the US. The Bank of Canada left the overnight target rate unchanged in May, but appears ready to continue its rate hiking cycle. However, we believe the recent high of 2.52% in 10-year Canadian government yields should hold for the time being.3
Neutral. The Reserve Bank of Australia (RBA) continued to hold rates steady at its May meeting. The quarterly Statement on Monetary Policy remained upbeat on the economy and revised up the RBA’s inflation expectations. However, it is still concerned with consumer spending and persistently low wage growth. The soft first quarter retail sales report confirmed those concerns and the unemployment rate has ticked up recently despite a strong job market. Due to continued above-trend economic growth coupled with low inflation and wage growth, the RBA will likely hold rates steady through the remainder of the year.
Neutral. We like current yield levels from a valuation perspective but expect the interest rate volatility observed over the last few months to persist for some time. In our view, the risks going forward are tilted toward higher yields as higher crude oil prices, rising core inflation and the uncertainty around minimum support prices for crops have increased fears of further upside surprises in headline inflation. We expect inflationary pressure to ease in the second half of 2018 and would likely favor buying local interest rates as inflation and crude oil prices 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; Scott Case, Portfolio Manager; Amritpal Sidhu, Quantitative Analyst
1 Source: Eurostat, May 31, 2018.
2 Source: Bank of Japan, Jan. 22, 2013.
3 Source: Bloomberg L.P., May 17, 2018.
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Tapering is the gradual winding down of central bank activities that aimed to reverse poor economic conditions.
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 iShares Barclays 20+ Yr Treas.Bond ETF (TLT) was unchanged in premarket trading Tuesday. Year-to-date, TLT has declined -5.16%, versus a 4.80% rise in the benchmark S&P 500 index during the same period.
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