The U.S. economy is on an upswing and asset markets are looking frothy. What happens when the Fed finally yields to this reality and raises short-term interest rates?

A new BlackRock Investment Institute publication breaks down the answers:

We expect the Fed to raise short-term interest rates in 2015—but probably not before September. Technological advances are set to keep dampening wage growth and inflation, reducing the need for the Fed to raise short-term rates as quickly and as high as in past cycles.
The longer the Fed waits, the greater the risk of asset price bubbles—and subsequent crashes. Years of easy money have inflated asset valuations and encouraged look-alike yield-seeking trades.
A glut of bank reserves and the rise of non-bank financing mean the Fed’s traditional tools for targeting short-term rates have lost their potency. We expect the Fed’s plan for ending zero rates to work, but do not rule out hiccups.
We suspect the Fed would prefer to see a gentle upward parallel shift in the yield curve, yet it has only a limited ability to influence longer-term rates. We detail how the absence of a steady buyer in the U.S. Treasury market will start to be felt in 2016.
We see the yield curve flattening a bit more over time due to strong investor demand for long-term bonds. Demand for high-quality liquid fixed income assets from regulated asset owners alone (think insurers and central banks) is set to outstrip net issuance to the tune of $3.5 trillion in 2015.
The forces anchoring bond yields lower are here to stay—and their effects could last longer than people think. Yet yields may have fallen too far. A less predictable Fed, rising bond and equity correlations and a rebound in eurozone growth could trigger yield spikes.
Asset markets show rising correlations and low return for risk, our quant research suggests. We see correlations rising further as the Fed raises rates. We are entering a period when both bonds and stocks could decline together. Poor trading liquidity could magnify any moves.

Investment Conclusions:

  • We expect volatility to rise across markets as the Fed nears the momentous decision of ending its zero interest rate policy (ZIRP).
  • Asset owners currently are requiring only a paltry risk premium to hold government bonds. This could reverse suddenly, if history is any guide.
  • The good news: High-quality liquid fixed income assets are supported by a global supply shortage this year and the next.
  • This trend should underpin demand for U.S. fixed income, especially given the Fed’s move to normalize monetary policy and negative nominal yields in much of the eurozone.
  • Credit spreads generally look attractive—but only on a relative basis.
  • Long-dated inflation-linked debt should deliver better returns than nominal government bonds, we think, even if inflation only rises moderately.
  • Global equities have performed well in recent tightening cycles – provided rate hikes are steady and predictable. Markets where gains have been driven by multiple expansion (rather than earnings growth) look most vulnerable to corrections.
  • European and Japanese equities should be resilient in the face of U.S. rate hikes as the European Central Bank and Bank of Japan press on with quantitative easing.
  • Angst about Fed rate rises, a rising US dollar and poor liquidity could roil emerging markets (EM).
  • Yet EM dollar debt looks attractive given a global dearth of high-yielding assets. EM equities look cheap, but many companies are poor stewards of capital. We generally like economies with strong reform momentum.
Ewen Cameron Watt, Rick Rieder, Russ Koesterick, Jean Boivin.

Ewen Cameron Watt, Rick Rieder, Russ Koesterick, Jean Boivin

BlackRock Investment Institute

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