Strategic Income Opportunities Fund Monthly Insight

Rates markets missing the mark

Mar 19, 2018

Markets have priced in higher rates for 2018, but the longer term view is a miss.

In similar fashion to the prior month, the February jobs report was considerably stronger than expected, with job gains of more than 300,000. We are impressed by the continued strength of the labor market. For perspective, in the time since 2010, it’s as if we’ve put the entire State of New York to work, or added the entire labor force of Australia. It is remarkable that an economy sporting an unemployment rate as low as 4.1% is still hiring at such a robust pace – and with no signs of slowing.

Upside surprises such as this have contributed to the recent volatility in rates as a stronger labor market suggests wages will increase, fueling higher inflation and ultimately, higher interest rates. (Rising inflation reduces the value of a bond’s future fixed payments to the investor; therefore, interest rates must rise to attract investors.)

But we believe many market observers aren’t considering that in addition to this employment dynamic, we’re also about to see roughly $300 billion of fiscal stimulus and tax benefits aggressively injected into the economy over the next few years. As the government plans to fund this by issuing debt, we can expect an increasing supply of government bonds in the next couple years, putting additional upward pressure on rates.

We expect the Federal Reserve to react by moving policy rates a quarter-point higher a total of three, or possibly four, more times this year (beginning with its March 21 meeting), and will probably move by the same calculus next year. While markets are adequately pricing in 2018’s likely path of rate normalization, it appears the continued path higher in 2019 is being severely underestimated.

In the Strategic Income Opportunities Fund, we slightly increased the fund’s duration from 0.4 to 0.9 years during the month of February. The majority of the fund’s duration is held in the 0- to 2-year part of the curve and we hold an outright short position on the back end. We reduced inflation protection positions (in breakeven form) on the front end of the curve as market inflation expectations repriced higher with the recent stronger data.

Outperformance with lower volatility

Outperformance with lower volatility

Source: Morningstar as of 2/28/18. Returns are from 2/28/17 through 2/28/18. Volatility is measured from 2/28/17 through 2/28/18 using daily returns. For standardized performance of the BlackRock Strategic Income Opportunities Fund, click here.

We decreased exposure to high yield, although we still feel comfortable holding the issuers we selected for their idiosyncratic stories, which are mainly on the front end of the credit curve. We believe securitized assets should continue to experience strong demand as we remain in an overall relatively low yield environment. We slightly reduced exposure to emerging markets, but still believe the sector should continue to be supported by synchronized global growth and strong fundamentals.

Read more about how the Strategic Income Opportunities portfolio management team is preparing for further interest rate movements and economic growth.

View fund commentary

Strategic Income Opportunities Monthly Insights

Subscribe to get timely market outlooks and portfolio positioning insights every month.