Rates outlook: Falling U.S. inflation may become a Fed concern by late 2018

Economic data have been mixed since the Bank of Canada increased the overnight rate 25 basis points in January.¹ 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.²

U.S.: 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 U.S. Treasuries, especially if geopolitical uncertainty begins to increase. However, with the market correction pushing yields higher in April, we remain neutral on U.S. rates in the near term.

Europe: 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.

China: 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.

Japan: 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.

Australia: 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 labour 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.