For qualified investors

Dissecting a rates disconnect

19-Jun-2017
By BlackRock Investment Institute , Richard Turnill

Key points

  1. Long-term yields fell last week mostly in response to another weak US inflation print, yet we still see modestly rising rates ahead.
  2. The Federal Reserve raised interest rates as expected and laid out its balance sheet normalisation plan. Financial stocks rose.
  3. MSCI may announce this week it is adding China A-shares to its indexes, with big implications for emerging market (EM) investors.

Dissecting a rates disconnect

The Fed proceeded down its policy normalisation path last week, yet weak US inflation data had a larger impact on rates as long-term yields fell. This disconnect doesn’t change our expectation that modestly rising US rates are ahead.

Chart of the week
G3 net debt issuance ex central bank purchses, 2007-2017

Chart of the week

Sources: BlackRock Investment Institute and Morgan Stanley, June 2017.
Notes: The bars show net government bond issuance for the US, eurozone and Japan, net of central bank purchases via quantitative easing programs. The weighted average spread is the average difference between 10-year and two-year yields in the three regions, weighted by nominal GDP. The figures for 2017 are estimates.

The Fed raised rates by 0.25% and indicated its balance sheet reduction would start this year. Quantitative easing globally decreased the amount of government bonds available for private investors, compressing the term premium — the extra yield that compensates investors for holding longer-term debt. See the chart above.

Term premiums in reverse

The term premium collapse had a ripple effect across markets, pushing investors into riskier fixed income and inflating valuations in assets from real estate to dividend stocks. This is what former Fed Chair Ben Bernanke termed the “portfolio rebalance channel.” The consequences of this process reversing are uncertain – the Fed has never before used asset reductions as a tightening tool. As such, we see the central bank unwinding cautiously– akin to crossing the river by feeling the stones. The benign market reaction last week suggests that, for now, it has succeeded in avoiding another “taper tantrum.”

The recent disconnect between Fed normalization and falling long-term rates is partly a result, in our view, of markets overly focusing on softening inflation data, while the Fed focuses more on the outlook. This dynamic could persist in the near term. We see sustained above-trend global growth and stabilizing inflation ahead, meaning the impact of the Fed's pace of normalization may be greater than bond markets currently anticipate.

Our base case is for modestly rising US rates. Global demand for income, fueled by still highly accommodative monetary policy in Europe and Japan, should help limit yield spikes. Front-end to intermediate US Treasuries, as well as credit and mortgages offer little cushion against Fed normalization hiccups. We prefer duration exposure in the long end and higher-quality credits for income. 

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  • The Fed raised rates for the second time in 2017. A close Bank of England vote potentially signaled a more hawkish stance after UK inflation spiked. Expectations rose for a 2017 Bank of Canada hike.
  • The International Energy Agency’s forecast for 2018 global oil supply to outpace demand, higher OPEC output in May and a disappointing US weekly inventory report sent oil prices to seven-month lows.
  • Global defensive shares gained as investors rotated away from tech stocks into less-loved corners of the market. A more hawkish Fed also helped drive up interest in financials.

 


  Date: Event
June 19-23 Fed officials Dudley, Evans, Fischer, Rosengren, Kaplan, Bullard, Mester and Powell speak
June 20 MSCI rules on inclusion of China A-shares in its indexes; special election in Georgia’s sixth congressional district
June 22 US, eurozone, Germany and Japan flash PMIs; US new home sales

MSCI will announce if it plans to include China’s domestic A-shares in its indexes — a decision in focus for EM and global equity benchmark investors, given the large size of China’s stock market and potential EM portfolio rebalancing required.

Richard Turnill
Managing Director, is Global Chief Investment Strategist for BlackRock
Richard Turnill is Global Chief Investment Strategist for BlackRock. He was previously Chief Investment Strategist for BlackRock’s Fixed Income and active ...

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