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Rate hikes: Sum total is key, not timing

18-Jan-2022
  • BlackRock

The year is off to a rocky start, with a jump in 10-year Treasury yields and a swoon in tech shares pulling down stocks. The culprit? Markets believe the Fed will raise rates sooner and more aggressively than expected. That’s not the story, in our view. The sum total of expected rate hikes remains low, thanks to a historically muted Fed response to inflation. Instead, the yield spike tells us that investors are less willing to pay a safety premium for bonds – and isn’t bad news for stocks per se.  

Key points

Fed rate hikes
Markets have been pricing in faster Fed rate rises, resulting in a rocky start this year. We believe the historically low sum total of rate hikes is key, not the timing.
Market backdrop
The stream of fourth-quarter corporate results picks up pace this week, with a key question whether companies can keep passing on input price increases.
Week ahead
The US CPI hit a 40-year high of 7% with little market reaction. The report gives more evidence that unusual supply factors are shaping the macro backdrop.
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Chart of the week
What’s driving the yield spike

US 10-year Treasury yield drivers, 2020-21

This chart shows that expectations for the future Fed funds rate have risen only modestly in recent weeks while 10-year Treasury yields have shot up. The main driver of this change has been an increase in the term premium.

Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and not subject to fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data  from Refinitiv Datastream, January 2022. Notes: The left chart shows the US 10-year Treasury yield along with New York Federal Reserve estimates of two components of that yield, expected interest rates and the term premium (the premium investors typically demand to hold riskier long-term government bonds). The right chart shows the cumulative breakdown of the change in the 10-year yield since its low point on Dec. 3, 2021.

The plunge in global government bond prices at the start of this year underscores the new market regime highlighted in our 2022 Global Outlook. The trigger was the Fed indicating a faster-than-expected policy normalisation, including speeding up the timeline for letting its bond portfolio shrink. Markets quickly priced in faster and more rate hikes this year against a backdrop of 40-year high inflation and a tight labor market. Equities have come under pressure as growth stocks lost some of their luster with the apparent prospect of higher interest rates making future earnings less attractive. Is all of this bad for equities? We don’t think so. What really matters for stocks, in our view, is that the Fed has kept signaling a low sum total of rate hikes. That hasn’t changed. Indeed, expectations for the future fed funds rate (the yellow line in the chart) have risen only modestly in the last six weeks, whereas 10-year Treasury yields have shot up (the green line). The driver instead is an increase in the term premium (the red line), the extra compensation investors demand for the risk of holding government bonds at historically low yield levels.

Understanding the drivers behind both the Fed’s muted response and the yield spike are key to navigating this environment. The Fed has adopted new policies that let inflation run a little hot to make up for below-target inflation in the past – and has now met its target. We believe the Fed and other central banks will want to keep living with inflation. Why? Today’s inflation is triggered by pandemic-induced supply constraints, a sea change from decades of demand-driven price pressures. Our upcoming Macro and market perspectives will explain why this matters: Tightening would only serve to hurt growth and employment at a time when the economy has not yet reached full capacity. Central banks are merely lifting their foot from the gas pedal by starting to remove emergency stimulus released when the pandemic hit in 2020, in our view. This muted response should only modestly increase historically low real, or inflation-adjusted, yields and underpin equity valuations.

The recent yield spike ostensibly has echoes of 2013’s “taper tantrum” when the Fed then flagged a reduction of bond purchases. Yet we see key differences: It’s not driven by fears of a sharp increase in the policy rate; growth is strong; and the Fed has honed its signaling. The Fed’s planned reduction of its balance could result in investors demanding a higher term premium for holding long-term bonds – but this need not be negative for equities in contrast to the taper tantrum, in our view. So far the Fed’s pivot on policy matters less for medium-term investors focused on the cumulative policy response.

We see three main risks. First and foremost: Central banks actually hit the brakes or markets think they might - a bad outcome for both stocks and bonds and one of the alternative scenarios to our base case laid out in our 2022 Global Outlook. We also considered the possibility of a sharper rise in the term premium relative to our base case for a more gradual increase depending on how the Fed handles the shrinking of its balance sheet. Second, we believe the Omicron strain presents downside risks to China’s growth outlook, especially given the influx of visitors for the Winter Olympics. We expect the country to maintain its zero-COVID policy – at least optically – in this politically important year. This heralds more restrictions on activity, even as Beijing appears bent on achieving its growth target this year by loosening policy. Third, we see potential conflict risks surrounding Iran’s nuclear ambitions, Russia’s massing of troops near Ukraine and, to a much lesser extent, Taiwan. These could rattle investors at a time the market’s attention to geopolitics is low. See our geopolitical risk dashboard. Our bottom line: We prefer equities in the inflationary backdrop of the strong restart of economic activity. We favor developed market stocks as we dial down risk slightly and are underweight government bonds.

Major spending shift
Prices in the US are rising at their fastest rate in about four decades. Learn why in our macro insights.
Eyes on inflation

Assets in review
Selected asset performance, 12 month return and range

The chart shows that Brent crude oil is the best performing asset over the past 12 months among a selected group of assets, while EM equities is the worst.

Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream as of January 14, 2022. Notes: The two ends of the bars show the lowest and highest returns at any point over the last 12-months and the dots represent current 12-month returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in US dollars, and the rest in local currencies. Indexes or prices used are, in descending order: spot Brent crude, MSCI USA Index, MSCI Europe Index, ICE US Dollar Index (DXY), MSCI Emerging Markets Index, Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, spot gold, Refinitiv Datastream Italy 10-year benchmark government bond index, Bank of America Merrill Lynch Global Broad Corporate Index, Refinitiv Datastream Germany 10-year benchmark government bond index and Refinitiv Datastream US 10-year benchmark government bond index.

US CPI hit a 40-year high of 7% with little market reaction. We see the report as more evidence that supply factors are shaping the macro backdrop. The fundamental culprits are the sputtering restart of supply and reallocation of resources spurred by the pandemic. The problem: policymakers can’t stabilise inflation without destroying activity. It’s a key reason why central banks have flagged a muted response to inflation. We see inflation settling at a level higher than pre-COVID.

Week ahead

Jan. 17 China urban investment, industrial output, retail sales and Q4 GDP
Jan. 18 UK unemployment data Bank of Japan policy decision
Jan. 19 UK CPI
Jan. 20 US Philly Fed Business Index

The of fourth-quarter corporate results picks up pace this week, with a key question whether companies can keep up their profistreamt margins by passing on input price increases. Investors may also get an early read on the impact of Omicron on future results. Some 8% of S&P 500 companies are set to report this week, dominated by financials, healthcare and real estate. UK inflation and employment could guide the Bank of England in the timing and magnitude of further rate rises.

Directional views

Strategic (long-term) and tactical (6-12 month) views on broad asset classes, January 2022

Legend Granular

Notes: Views are from a US dollar perspective, December 2021. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any particular funds, strategy or security.

Our granular views indicate how we think individual assets will perform against broad asset classes. We indicate different levels of conviction.

Tactical granular views

Six to 12-month tactical views on selected assets vs. broad global asset classes by level of conviction, January 2022

Legend Granular

Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index. Source: BlackRock Investment Institute Notes: Views are from a US dollar perspective as of  December 2021. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast or guarantee of future results. This information should not be relied upon as investment advice regarding any particular fund, strategy or security.

Read details about our investment themes and more in our 2022 Global outlook.

Growth edges up

 

We expect inflation to be persistent and settle above pre-COVID levels. We expect central banks to kick off rate hikes but remain more tolerant of price pressures, keeping real interest rates historically low and supportive of risk assets.

    • Inflation is being driven by the unusual restart dynamics of extraordinary demand bumping up against supply bottlenecks. We expect many COVID-related supply-demand imbalances to resolve over the year.
    • The policy response to rising inflation isn’t uniform. The Fed and the ECB are more tolerant of inflation, even as the Fed has started to warn of inflation risks.
    • Other developed market (DM) central banks have signaled policy rate paths with steeper initial increases, and many of their emerging market (EM) counterparts have already lifted off.
    • The Fed has achieved its new inflation goal to make up for past misses and sees full employment being reached this year. This is the justification for the three rate hikes it has suggested for 2022. This is more than we expected, but we believe the total sum of hikes is unchanged and historically muted – and more important to markets.
    • The Fed has sped up its tapering of bond purchases and has indicated it may start to trim its bond portfolio earlier than expected by letting bonds run off when they mature.
    • Investment implication: We prefer equities over fixed income and remain overweight inflation-linked bonds.
Policy Pause

 

A unique mix of events - the restart of economic activity, virus strains, supply-driven inflation and new central bank frameworks - could cause markets and policymakers to misread the current surge in inflation.

    • We keep the big picture in mind: We see the restart rolling on, inflation meeting a muted central bank response, and real rates remaining historically low.
    • We do see increasing risks around this base case: Central banks could revert to their old policy response, and growth could surprise on the upside or disappoint.
    • There’s also a risk markets misread China’s policy. The country has emphasized social objectives and quality growth over quantity in regulatory crackdowns that have spooked some investors. Yet policymakers can no longer ignore the growth slowdown, and we expect incremental loosening across three pillars - monetary, fiscal and regulatory.
    • Investment implication: We have trimmed risk-taking amid an unusually wide range of outcomes.
Raising resilience

 

Climate risk is investment risk, and the narrowing window for governments to reach net-zero goals means that investors need to start adapting their portfolios today. The net-zero journey is not just a 2050 story, it's a now story.

    • Sustainability cuts across multiple dimensions: the outlook for inflation, geopolitics and policy. The green transition comes with costs and higher inflation, yet the economic outlook is unambiguously brighter than a scenario of no climate action or a disorderly transition. Both would generate lower growth and higher inflation, in our view.
    • Risks around a disorderly transition are high – particularly if execution fails to match governments’ ambitions to cut emissions.
    • We favor sectors with clear transition plans. Over a strategic horizon, we like sectors that stand to benefit more from the transition, such as tech and healthcare because of their relatively low carbon emissions.
    • Investment implication: We favor DM equities over EM as we see them as better positioned in the green transition.
Jean Boivin
Head – BlackRock Investment Institute
Wei Li
Global Chief Investment Strategist – BlackRock Investment Institute
Alex Brazier
Deputy Head – BlackRock Investment Institute
Elga Bartsch
Head ofMacro Research — BlackRock Investment Institute
Scott Thiel
Chief Fixed Income Strategist – BlackRock Investment Institute

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