Interest Rate Outlook: Above-Trend Growth Could Cause Us Inflation Later in 2018
Invesco Fixed Income shares its views on rates around the world
We expect US interest rates to be range-bound in the first half of 2018, but with a risk of higher yields in the second half. Our rates view is driven by our analysis of growth, inflation and monetary policy in the US and globally. Our models estimate that US growth approached a near cycle high at just above 3% in the fourth quarter of 2017. Growth should remain strongly above trend at 2.75%3 in 2018.
Inflation is likely to remain low for the first half of this year. Headwinds facing the housing and auto markets could drag down inflation, causing it to remain lower (around 1.8%3) than most have predicted in 2018. We expect the Federal Reserve (Fed) to hike rates twice this year, representing a gradual rate of policy tightening that is unlikely to impact the economy. However, if we see persistent wage increases going forward, similar to the wage pickup in January, we may raise our inflation forecast for 2018 above our current expectation of 1.8%.3
Treasury supply may increase in 2018, driven by increased government spending and smaller Fed bond purchases as quantitative easing (QE) is tapered. This supply increase will likely present a headwind for yields later in the year. If our view on persistent low inflation is correct, the yield on the 10-year US Treasury should remain capped at around 2.65%3 in the first half of 2018. However, if wages continue to rise sharply, the Fed hiking cycle may extend into 2019 and 2020, and at a faster-than-expected pace. Increased expectations of further rate hikes in the medium term and perceived higher inflation risk could steepen the US Treasury yield curve and push interest rates higher.
The positive growth impulse continues in Europe, although euro-area inflation was less than forecast in December. Nevertheless, the European Central Bank (ECB) minutes presented an optimistic view on inflation and clear signs that forward guidance on QE tapering appears likely in the near future. Hawkish comments from policymakers have also dominated public debate recently, although some have raised concerns over the euro’s strength. Bund yields have sold off slightly since the start of the year in a sign that the market is preparing for policy normalization. Some economists have also brought forward their estimates of when the ECB will set an end date for its bond-buying program. While no action is likely in January, we expect the ECB to announce an end date by June.
China’s onshore government bond yield curve bull steepened in January 2018, thanks to easier liquidity conditions and improved sentiment. The People’s Bank of China (PBOC) has been somewhat more generous in terms of liquidity injection, but onshore investors remain cautious. This is reflected in the steeper 10-year part of the government yield curve. Financial regulatory tightening has pressured nonbank financial institutions, thus, we see limited room for the PBOC to tighten liquidity further from here. We continue to find attractive opportunities in onshore government bonds. If tax implications are considered, government bond yields are appealing compared to lending rates, in our view. With new asset management rules and liquidity management guidance in place, we expect demand for government bonds to pick up.
The Japanese economy continues to perform well. Exports have especially benefited from increased global demand. We expect this trend to continue for the foreseeable future. In the near term, the market focus will likely be on spring wage negotiations. Prime Minister Abe is pushing companies to provide meaningful increases to create a virtuous circle of higher wages, higher demand and higher prices (i.e., the good type of inflation). However, there is a tendency for wage discussions to disappoint to the downside. We expect the Bank of Japan (BOJ) to remain on hold, and expect 10-year Japanese government bond yields to remain range-bound for now (0% to 0.1%3). However, the market could react sharply if the BOJ shows an inclination toward removing stimulus.
Brexit uncertainty continues to dampen business and consumer confidence, however, the economy is not collapsing despite negative real wage growth and slowing house price gains. Trade talks with the European Union (EU) are yet to get underway, but calls for a second referendum (on the final deal) are intensifying. With the clock ticking down on the UK’s March 2019 departure date, our base case is that there will be a “can kick,” or delay in a final agreement. This could result in the UK’s membership in the EU being temporarily extended. Signs that the status quo will remain for an additional two years or so would likely restore confidence and lead to implementation of deferred investment. Regarding monetary policy, we expect one rate hike in 2018 and one more in 2019. With Brexit edging closer to a more amicable solution and the global economy picking up, there is a growing probability that market participants will price in more hikes in the coming months.
Employment growth has been strong enough that the Bank of Canada (BOC) hiked its overnight target rate to 1.25% in January.1 The BOC statement attempted to balance the view that growth was near capacity with concerns that raising rates too quickly could cause the economic expansion to stall. The 10-year yield has broken through its previous peak of 2.15% on the growth story and a modest pickup in inflation.2 We believe yields should continue to move higher from these levels.
The Reserve Bank of Australia (RBA) did not meet in January and thus issued no new statement. The strong December employment report marked two months of higher-than-expected job growth. The unemployment rate has ticked up but this was due to an increase in the participation rate, which is approaching an all-time high. Despite the strong employment numbers, wage inflation remains low. We remain neutral on Australian rates but continued strong economic data could put the RBA in play sooner than the market currently expects.
Government bond yields have risen significantly since August after several upside inflation surprises. Inflation has been driven by higher food prices and upward pressure on rents caused by increased public employee housing allowances. We believe that inflation will likely hover around 5%3 during the first half of 2018 before reverting to 4.5%3 in the second half. We expect the Reserve Bank of India (RBI) to maintain a hawkish stance, but stay on hold through the first half of 2018. We also believe its next move will be a rate hike versus a cut. Given the lack of monetary support, it is likely that fiscal dynamics will be the key driver of interest rates going forward and we will be watching February’s annual budget announcement closely. While we believe current rate levels are very attractive, we are waiting for more clarity on the fiscal outlook and indications from the RBI before investing in Indian interest rates.
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: Bank of Canada, Jan. 17, 2018
2 Source: Bloomberg L.P., data as of Sept. 27, 2017
3 Source: Invesco Fixed Income estimates, Feb. 8, 2018
Robert B. Waldner, Jr.,
CFA Chief Strategist and Head of Multi-Sector
Rob Waldner is Chief Strategist and Head of Multi-Sector for Invesco Fixed Income (IFI). Mr. Waldner has overall management responsibility for the IFI public credit asset class teams and the Multi-Sector team. In this role, he is responsible for oversight of the portfolio construction process for IFI’s public security portfolios. Mr. Waldner chairs the IFI Investment Strategy team and is responsible for oversight of the overall IFI investment process. He joined Invesco in 2013.
Prior to joining Invesco, Mr. Waldner worked with Franklin Templeton for 17 years. At Franklin Templeton, he was a senior strategist and senior portfolio manager. He was the lead manager for Franklin absolute return strategies, and a member of the Fixed Income Policy Committee. Mr. Waldner was instrumental in the launch of a number of new strategies on the Franklin Templeton fixed income platform. Previously, Mr. Waldner was a member of the Macro team at Omega Advisors and a portfolio manager with Glaxo (Bermuda) Ltd. He entered the industry in 1986.
Mr. Waldner earned a BSE degree in civil engineering from Princeton University, graduating magna cum laude in 1986. He is a CFA charterholder.
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Interest rate outlook: Above-trend growth could cause US inflation later in 2018 by Invesco