Interest Rates Are Going Nowhere Fast

From Invesco: Invesco Fixed Income shares its views on rates around the world, including a neutral outlook for U.S. interest rates.

US: Neutral. We expect US rates to stay range-bound due to growing trade worries and above-trend growth. Assuming no large trade-driven shocks, US growth is likely to remain supported by stronger energy sector capital expenditures, strong job growth and consumption. We expect 2018 gross domestic product (GDP) growth of around 2.8%, one percent above our estimate of the long-term sustainable trend. Core inflation continues to be benign, and we expect it to peak in the next two months at around 2.3%. However, softer rental and service costs should drive it back below 2% toward the end of the year. Trade-related actions have increased the risk of tighter global financial conditions, and the possibility that further tariffs could be imposed in the late summer or fall may cause asset volatility. Treasury prices may benefit if volatility picks up.

Europe: Underweight. Core European rates have traded firmly in the last two months, benefiting from a flight to quality on the back of an uncertain global backdrop, Italian politics, and the dovish interpretation of the June European Central Bank meeting. In the second half of the year, we continue to expect European economic data to show substantial above-trend growth. It is likely that first half softness in the data represented a moderation of activity, rather than a major slowdown. We believe the market will begin to price greater term premium into the European yield curve given the prevailing strength in the economy and current depressed valuations. We retain a modest underweight exposure to European rates.

China: Overweight. We expect a steepening government bond yield curve and continue to see room for short-term rates to perform well as a result of monetary easing measures announced by the People’s Bank of China and market expectations of potentially more proactive fiscal policies. Detailed rules on bank wealth management products are expected to lead to higher demand for short-term bonds. Longer-term government bonds may not look as attractive as short-term, high-quality credit bonds at current levels. We expect spreads of policy bank bonds and high-quality credit bonds to tighten further in the near term.

Japan: Neutral. The Bank of Japan (BOJ) revealed several small policy adjustments at its July meeting, including widening the trading range of the 10-year Japanese government bond (JGB) yield under yield curve control, reducing the size of reserve balances to which negative interest rates are applied and altering its stock exchange traded fund-buying program to include a greater proportion of the Tokyo Stock Price Index. The BOJ disappointed bearish speculation as it introduced forward guidance that vowed to maintain extremely low interest rates for an extended period of time — this caused a rally in JGBs. Looking ahead, we expect the economy to bounce back from its weak first quarter led by a pickup in exports and private sector demand.

UK: Neutral. Prime Minister Theresa May’s cabinet is struggling to adopt collective responsibility for the Brexit negotiating strategy drafted at the beginning of July. UK citizens voted to leave the European Union (EU) over two years ago. With nine months until the departure date, we are no closer to understanding the UK’s likely trade relationship with the EU post-Brexit. Multiple outcomes are in play: a vote of no confidence in Theresa May, another general election, a second referendum, a deferred departure date, a hard Brexit or the possibility that the UK remains a member of the EU. As UK politicians head off on summer vacation, there will likely be a lull in proceedings, but tensions may heighten when they return in September. Our base case is that the UK will opt for a soft Brexit at worst, but a resolution is unlikely to be achieved until the last minute.

Canada: Neutral. The Bank of Canada (BOC) hiked the overnight rate to 1.75% at its July meeting.1 The hike reflects the fact that, despite stalled trade negotiations with the US, the BOC believes a slow path of rate hikes remains appropriate. Economic data have been somewhat mixed with housing growth slowing, employment continuing to be positive and inflation slowly moving higher. Yields on 10-year Canadian government bonds peaked in May at 2.52% and have since fallen to just above 2.0%, approximately where they started the year.2 In our view, it will likely be difficult for yields to rally much further from here.

Australia: Neutral. The data out of Australia remain unexciting. Employment growth for June was strong, but an increase in labor force participation kept the unemployment rate at 5.4%.3 Housing credit growth has slowed, but it appears manageable. Wage growth remains lackluster and inflation constrained, allowing the Reserve Bank of Australia to keep interest rates unchanged. The 10-year government bond yield sits near the lowest level of the year and may have trouble rallying to lower levels unless global growth slows further.

India: Neutral. We expect Indian yields to stay range-bound, with value buyers stepping in if 10-year government bond yields reach 8%. Although attractive valuations are likely to contain any significant sell-off, we believe macroeconomic risks are tilted toward higher yields. An increase in core inflation over the past few months and higher crude oil prices, coupled with the recent hike in minimum support prices for crops have increased fears of further upside surprises in headline inflation. Core consumer price inflation increased to 6.35% in June, and we think the risk of another rate hike at the Reserve Bank of India’s August meeting has increased significantly as a result.4

1 Source: Bank of Canada, July 11, 2018.
2 Source: Bloomberg L.P., May 17, 2018 to July 20, 2018.
3 Source: Australian Bureau of Statistics, July 19, 2018.
4 Source: Bloomberg L.P., July 12, 2018.

Important information

Gross domestic product is a broad indicator of a region’s economic activity, measuring the monetary value of all the finished goods and services produced in that region over a specified period of time.

Policy bank bonds are those issued by the three Chinese policy banks as the primary source of funding (China Development Bank, Agricultural Development Bank of China, and Export-Import Bank of China).

The Tokyo Stock Price Index (Topix) is a free-float-adjusted market-capitalization-weighted index measuring the performance of large-cap stocks listed on the Tokyo Stock Exchange.

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 20+ Yr Treas.Bond ETF (TLT) rose $0.18 (+0.15%) in premarket trading Thursday. Year-to-date, TLT has declined -5.57%, versus a 7.40% rise in the benchmark S&P 500 index during the same period.

TLT currently has an ETF Daily News SMART Grade of B (Buy), and is ranked #16 of 28 ETFs in the Government Bonds ETFs category.

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