Interest Rate Trends: Continuing the Climb Higher

After a turbulent April, May trends seem to be signaling that in the short term, rate markets are likely to trade within a new range – and that in the long-run, higher rates are likely to return.

Last month we witnessed notable changes in the fixed income landscape. Perhaps most importantly, the global rates bellwether – U.S. 10-year Treasuries – broke through three percent yield. Looking ahead, all signs point to sustained higher rates in the U.S.:

Growth is expected to recover in the second half, as the Trump tax cuts work their way through the system.

  • Treasury supply, fuelled by government borrowing and fed by the Federal Reserve’s unwind of quantitative easing, is ballooning.
  • Inflation seems finally to be stirring towards the Fed’s target range.

Over the past few months, as forces pushed rates higher in the U.S., Canadian rates followed suit, and the Canada yield curve followed the flattening trend as well. We see the 10-year Government of Canada benchmark bond trading in the 2.5-to-2.75-percent range over the second quarter, with a bias toward the higher end.

Like the Bank of Canada, we continue to be on the lookout for signs that higher rates are adversely affecting the economy, particularly in housing and broad consumption. At the moment though, the chief offset is oil. We expect higher oil prices to induce a positive shock to Canada’s terms of trade. It will also allow the Bank some leeway to continue to remove monetary accommodation, since stronger incomes from energy should help cushion the impact of higher rates on the consumer.

Those factors alter our short-term outlook for policy rates. We now anticipate that the Bank will raise the overnight rate to 1.5 percent at July’s meeting. We continue to expect this to be the last hike of 2018.

It makes sense for investors to reassess rate risk. In our iShares Strategic Fixed Income ETFs, we recently made tactical adjustments, reducing nominal interest rate risk and garnering some inflation protection by increasing real rate risk exposure. Even more tactically, High Yield spreads have tightened while EM debt spreads have widened, providing better relative value.

Aubrey Basdeo is a Managing Director and Head of Canadian Fixed Income for BlackRock. He is a regular contributor to The Blog in Canada.

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