Interest rate outlook in North America - Part 2

As pointed out in our April 15 Strategy Note on North American interest rates, “10-year U.S. Treasury yields started the year at 2.46% and by early February had shot up to 2.80%, thereafter peaking at 2.95% on February 21. On March 27, for the first time since early February, however, the 10-year yield fell back below 2.8%. However, in the second half of April, the U.S. Treasury 10-year bond reversed and shot back up to a high of 3.03% before ending the month at 2.95%. We had admitted in that Note that forecasting where U.S. long term interest rates would go was not easy. “There are U.S. deficits to fund plus the Fed will be upping its pace of Quantitative Tightening by capping the amount of proceeds it reinvests from maturing securities, starting at $10 billion per month, and gradually increasing the cap over the year to September to a total of $50 billion per month. It has been estimated that this Fed balance sheet reduction would raise long term interest rates by 20 to 40 basis points which appears to have already been reflected through the rise in rates year to date”.

We did conclude in that Note that we might expect relatively tame inflation on the basis of moderating growth in the U.S. economy, which would leads us to expect long-term interest rates to remain range-bound. However, we admitted that there were a lot of negative and positive factors which would be influencing U.S. long term rates.

Among the negative factors, we highlighted inflation moving above the Fed’s two-percent target, as a result of higher wages, declining labour availability, higher housing and healthcare costs, and protectionist trade policies pushing up the price of imports. As mentioned above, the lack of Fed buying of Treasuries and rising budget deficits meant a sharp rise in net Treasury issuance this year compared to last year (almost triple 2017’s issuance of $550 billion).

On the positive side in terms of bond prices, 10-year U.S. Treasuries were yielding about 150 basis points more than the average among G-7 issuers (and that gap has widened in the second half of April). In addition, 10-year Treasuries have been yielding about 80 basis points above CPI - the biggest premium over inflation since 2016 and about 1% more than S&P 500 dividends – the biggest spread in four years. Finally, it seemed that the market had largely priced in the three Fed rate hikes the dot plot called for this year. We concluded that these factors should make U.S. 10-year Treasuries attractive to foreign investors. The recent increase in volatility in equity markets would also normally drive capital flows to safe haven long treasuries although in recent weeks volatility has declined somewhat.

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