• Revenge of the NIRPs. The Bank of Japan’s (BoJ) surprise expansion of its policy accommodation to include Negative Interest Rate Policy (NIRP) sparks a reassessment of where the interest rate floor might lie for the Federal Reserve. Bond markets in January priced out virtually all expectations for normalization in 2016, leading to some speculation on negative rates should the Fed need to shift to an accommodative stance.
  • The Limits to Monetary Policy. BoJ Governor Haruhiko Kuroda says, “It is no exaggeration that QQE with a negative interest rate is the most powerful monetary policy framework in the history of modern central banking.” ECB President Mario Draghi reminds us that “there are no limits to how far we are willing to deploy our instruments.” A closer look, however, reveals real vulnerabilities in these arguments.
  • Consequences of the Collapse. With “V-shaped” recovery expectations for commodity prices from last year being replaced by “L-shaped” expectations, the consequences register in credit markets. Lower long-run cash flows lead to greater leverage, credit risk and now, in recognition of those facts, downgrades. This fallen angel supply adds to the valuation concerns for the higher-quality section of the high-yield market and we remain cautiously neutral.

Strategy and outlook

Delaying Fed normalization and the prospects of pricing in some even remote possibility of negative interest rates represents a meaningful inflection point to the outlook. While monetary policy alone cannot, in our assessment, address the fundamental issues underlying today’s credit cycle—excess capacity in the commodity sectors—the possibility of easing the pressure of a stronger dollar on weakening commodity prices and shrinking liquidity may for a short time relieve some of the negative sentiment that our longer-run outlook reflects. As such, we recommend some tactical adjustments to our strategy. Those flip our yield curve outlook to favor the short end of the curve over the long end, as any further easing of expectations for Fed normalization should continue to benefit this segment of the market. Reducing those expectations further reduces pressure for a stronger dollar. And that favors non-USD fixed income investments as well as emerging market debt. We moved up our recommendations last month on DM non-USD on this possibility and tactically for this month move to overweight. EM external sovereign debt may also benefit so we upgrade that segment to neutral from underweight but due to their greater vulnerabilities leave corporate EM at underweight.

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The sector performance and yields listed are represented by, respectively: Barclays US High Yield Index, S&P Leveraged Loan Index, Barclays US Securitized Ex-MBS Index, Barclays US Mortgage Backed Securities Index, Barclays US Corporate Investment Grade Index, Barclays Global Aggregate ex-USD Index, JP Morgan EMBI Global Diversified Index, Barclays US Inflation Protected Securities Index and Barclays US Treasury Index. The reference indices are represented by the Barclays US Aggregate and the Barclays Municipal Bond Index.

Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments.

Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets, in concentrations of single countries or smaller capital markets.

Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

The opinions expressed are those of BlackRock as of Jan. 14, 2016, and may change as subsequent conditions vary. Information and opinions are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable. The information contained in this report is not necessarily all-inclusive and is not guaranteed as to accuracy. Past performance does not guarantee future results. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. Investment involves risk. Reliance upon information in this report is at the sole discretion of the reader.

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