Dissecting a rates disconnect

19 jun 2017

Key points

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

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

G3 net debt issuance ex central bank purchases, 2007-2017

G3 net debt issuance ex central bank purchases, 2007-2017

Sources: BlackRock Investment Institute and Morgan Stanley, June 2017.
Notes: The bars show net government bond issuance for the U.S., 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 U.S. 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 U.S. 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. 


  Date: vertical line 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 23 U.S., eurozone, Germany and Japan flash PMIs; U.S. 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.

  • 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 U.S. 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.

Global snapshot

Weekly and 12-month performance of selected assets


EquitiesWeekYTD12 MonthsDiv. Yield
U.S. Large Caps 0.1% 8.7% 17.1% 2.0%
U.S. Small Caps -1.0% 4.3% 24.3% 1.2%
Non-U.S. World -0.4% 14.0% 24.0% 3.1%
Non-U.S. Developed 0.0% 14.3% 24.0% 3.2%
Japan 0.2% 10.4% 21.6% 2.2%
Emerging -1.4% 17.2% 28.3% 2.7%
Asia ex-Japan -1.5% 21.4% 30.0% 2.5%
BondsWeekYTD12 MonthsYield
U.S. Treasuries 0.3% 2.4% -1.3% 2.2%
U.S. TIPS -0.5% 1.1% 0.3% 2.1%
U.S. Investment Grade 0.5% 4.1% 3.3% 3.1%
U.S. High Yield 0.1% 5.0% 13.8% 5.5%
U.S. Municipals 0.0% 4.1% 0.4% 2.2%
Non-U.S. Developed 0.3% 6.2% -2.9% 0.7%
Emerging Market $ Bonds 0.0% 6.9%  9.2% 5.2%
CommoditiesWeekYTD12 MonthsLevel
Brent Crude Oil -1.6% -16.6% 0.4% $47.4
Gold -1.0% 9.3% -1.9% $1,253.7
Copper  -2.4% 2.3% 24.9% $5,663.0
CurrenciesWeekYTD12 MonthsLevel
Euro/USD 0.0% 6.5% -0.2% 1.12
USD/Yen 0.5% -5.2% 6.3% 110.88
Pound/USD 0.3% 3.6% -10.0% 1.28

Source: Bloomberg. As of June 16, 2017.
Notes: Weekly data through Friday. Equity and bond performance are measured in total index returns in U.S. dollars. U.S. large caps are represented by the S&P 500 Index; U.S. small caps are represented by the Russell 2000 Index; Non-U.S. world equity by the MSCI ACWI ex U.S.; non-U.S. developed equity by the MSCI EAFE Index; Japan, Emerging and Asia ex-Japan by their respective MSCI Indexes; U.S. Treasuries by the Bloomberg Barclays U.S. Treasury Index; U.S. TIPS by the U.S. Treasury Inflation Notes Total Return Index; U.S. investment grade by the Bloomberg Barclays U.S. Corporate Index; U.S. high yield by the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index; U.S. municipals by the Bloomberg Barclays Municipal Bond Index; non-U.S. developed bonds by the Bloomberg Barclays Global Aggregate ex USD; and emerging market $ bonds by the JP Morgan EMBI Global Diversified Index. Brent crude oil prices are in U.S. dollars per barrel, gold prices are in U.S. dollar per troy ounce and copper prices are in U.S. dollar per metric ton. The Euro/USD level is represented by U.S. dollar per euro, USD/JPY by yen per U.S. dollar and Pound/USD by U.S. dollar per pound. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.

Asset class views

Views from a U.S. dollar perspective over a three-month horizon

Table: Asset class views from a U.S. dollar perspective


Richard Turnill
Global Chief Investment Strategist, BlackRock Investment Institute
Richard Turnill is Global Chief Investment Strategist for BlackRock. He was previously Chief Investment Strategist for BlackRock’s Fixed Income and active ...
Isabelle Mateos y Lago
Chief Multi-Asset Strategist
Kate Moore
Chief Equity Strategist
Jeffrey Rosenberg
Chief Fixed Income Strategist