Fixed Income

Sentiment in the US is jubilant, economically if not politically

Scott Thiel |17-Feb-2017

Confidence is high in the US, but that does not mean bond investors can be complacent.

The US economy is reflating – but so are risks

Sentiment in the US is jubilant, economically if not politically.
The University of Michigan’s consumer-sentiment index hit a 13-year high in January; although it dipped slightly in February, there have still only been five higher readings in the past decade (source: University of Michigan, February 2017). Gallup’s US economic-confidence index similarly reached its highest monthly average for the past nine years in January (source: Gallup, February 2017), while the National Federation of Independent Business’s index of small-business optimism hit its highest level since 2004 in December (source: NFIB, January 2017).

We would typically tend to place less weight on survey data of this kind, as aggregate opinion can change rapidly and in unexpected ways, but the pervasiveness of this optimism is striking. Importantly, the Federal Reserve itself has taken note: in February it observed that ‘measures of consumer and business sentiment have improved of late’ (source: Federal Reserve, February 2017).

We believe it may be important to be flexible in this environment, to consider taking advantage of the best opportunities in fixed-income markets globally

All this may augur the Federal Reserve increasing interest rates faster than some expect. The central bank is now very close to meeting both of its mandates: maximum employment and stable prices. On employment, after a modestly weaker fourth quarter, the labour market was stronger in January. Non-farm payroll growth came in at 227,000 jobs, considerably better than the consensus expectation of 175,000 jobs (source: Bureau of Labor Statistics, February 2017). And although the unemployment rate did tick up slightly last month from 4.7% to 4.8% (source: Bureau of Labor Statistics, February 2017), it has been hovering around non-accelerating inflation rate of unemployment (NAIRU) levels – the level of unemployment below which inflation rises – in recent months. Meanwhile, both the headline and core consumer price index numbers are close to 2%, the Federal Reserve’s stated inflation goal (source: Bureau of Labor Statistics, January 2017). We expect that the jobs market will remain healthy and nudge the unemployment rate towards the low-4% region by the year-end, which would also put upwards pressure on wages and so inflation.

Then of course there is the potential implementation of lower taxes and increased fiscal spending by the new US administration, which may well serve to accelerate the pickup in inflation that already appeared underway before the election. A March hike is therefore still very much on the table. Philadelphia Federal Reserve Bank President Patrick Harker commented ahead of the meeting that ‘March should be considered as a potential for another 25 basis point increase’ (source: Reuters, February 2017). In turn, any such action should further support the already relatively strong US dollar.

In summary, for investors this combination of positive economic data, rising inflation rates, and tighter monetary policy should, we believe benefit risk assets rather than risk-free rates. However, it will be important to be flexible in this environment, to consider taking advantage of the best opportunities in fixed-income markets globally, to minimise the negative impact of rising rates such as by considering going short duration, and to utilise strategies that can benefit from bouts of volatility and neutralise beta, such as absolute-return type strategies. We believe assets that offer the potential for higher upside in an inflationary environment, with Treasury Inflation-Protected Securities being a clear example, may also prove valuable in this reflationary regime.

Scott Thiel
Managing Director, BlackRock’s Deputy Chief Investment Officer of Fixed Income
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This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of February 2017 and may change as subsequent conditions vary.

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