Summary
- We don't expect major central bank rate cuts this year, so we prefer to gain on short-term bonds, high-quality debt, and agency mortgage-backed securities.
- U.S. stocks rose, and Treasury yields were largely flat. Fourth-quarter U.S. GDP was resilient, but the decline in consumer spending suggests growth is slowing rapidly.
- The Fed and the European Central Bank are anchoring this week's policy decisions. We see them raising and maintaining higher rates for longer than the market expects.
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Transcription
The Federal Reserve and the European Central Bank are expected to raise rates again this week to combat inflation.
But markets are pricing in rate cuts in 2023, even as both central banks insist they will stay the course.
1) Higher official rates for longer
We see the disconnect working in favor of central banks.
Inflation should fall a lot, but not to 2% in our view.
Like central banks, we're looking for sustainable wage pressure reductions. They'll want to see this before declaring victory over inflation, so rate cuts are a long way off.
2) Risks that generate higher returns in the long term
This is one reason we prefer short-term bonds. Another is that we see investors demanding more long-term bonds.
This could happen if the Bank of Japan changes its yield curve control policy and this causes market dislocations.
This could also happen during the fight to raise the US debt ceiling, even if we hope the negotiations work out.
3) Opportunities in short-term fixed income
Short-term government bonds and investment-grade credit now offer some of the highest yields in two decades.
We prefer them for income. We also like agency mortgage-backed securities for income diversification.
Global investment-grade credit offers an even higher yield than short-term bonds and should withstand a downturn.
We like short-term government bonds and high-quality credit for their income potential.
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Major central banks are expected to raise interest rates again this week and keep them higher, in contrast to market sentiment for cuts this year. We see this disconnect resolving and favoring higher rates. This is because we believe inflation will fall rapidly but remain above target. Maintaining high interest rates and the political dispute over raising the US debt limit are market risks. We prefer to make money and like short-term government bonds, high-quality credit, and mortgage-backed securities.
Surrender is back
Investment Grade and Short-Term Government Debt Yields, 2002-2022 (BlackRock Investment Institute, with Refinitiv data, January 2023)
Notes: The chart shows returns for the Bloomberg Global Aggregate Corporate Index and the two-year U.S. Treasury benchmark.
Income has finally returned to fixed income, thanks to higher yields and coupons. Short-term government bonds and investment-grade (IG) credit now offer some of the highest yields in two decades. See the chart. We prefer to make quick money from these high-quality fixed-income assets as rates rise and remain high. The appeal of fixed income remains intact the longer central banks keep rates near their highs. The lack of duration—or the sensitivity of bond prices to interest rates—in short-term bonds also helps preserve income even if yields rise again. Global IG Credit offers high-quality liquid income, and we believe the strong balance sheets of high-quality companies that have refinanced debt at lower rates can withstand the upcoming mild recession. We also like agency mortgage-backed securities (MBS) for income diversification.
We see major central banks on the path to excessive policy tightening because they are concerned about the persistence of core inflation, excluding food and energy prices. US PCE data confirmed that the outlook for core inflation has not improved and is expected to remain well above monetary policy targets in 2024. Basic services inflation is proving sticky, even with falling commodity prices. This stickiness is related to wage pressures in the labor market, which we see remaining tense. We believe central banks will want more evidence that core inflation and wage pressures are declining sustainably before declaring victory over inflation and considering policy easing. This will take a long time and is unlikely to happen this year, in our view.
This week, the Fed and the ECB are expected to raise rates further. We expect the Fed to raise 0.25% and the ECB to raise 0.5%, with more hikes likely to follow. Therefore, we see them keeping rates high. But markets are pricing in rate cuts in 2023, even with both central banks insisting on staying the course. This disconnect needs to be addressed, and we believe it will be favorable to higher rates, as inflation persists above the central banks' 2% target. Remaining high rates are one of the reasons we prefer to profit from shorter-term bonds.
Term premium yield
Another reason is the term premium: the remuneration investors demand for holding long-term government bonds. We see investors seeking a higher term premium with higher inflation and other short-term risks on the horizon. Political pressure on the Bank of Japan to change its yield curve control policy will likely increase with inflation at a four-decade high. The risk: a global spillover from rising Japanese government bond yields to global yields. We believe that exiting yield curve control would be like exiting currency peg: even adjustments can lead to sudden market dislocations.
The risks of raising the US debt ceiling are also in focus after the US hit its debt ceiling this month, reinforcing our view that investors will continue to demand a bonus over a deadline. Negotiations are expected to continue this summer and could be as difficult as in 2011, when S&P Global downgraded the US credit rating to triple-A. Eventually, we expect a resolution. If a US default were to occur, it would likely be technical in nature, meaning the US would prioritize debt payments over other obligations. We expect only a temporary rise in yields on select Treasury securities as the default date approaches. Another debt ceiling impasse could also pressure risk assets, as in previous episodes – this keeps us cautious on US equities.
Our bottom line
Remaining high rates and the political battle over the US debt ceiling are market risks. At this point, let's take a granular view of fixed income. Tactically, we prefer short-term government bonds, high-quality credit, and agency mortgage-backed securities for attractive income.
Market context
US stocks recovered and bond yields remained largely stable, with European and emerging market stocks outperforming the US in terms of investor inflows. US GDP was resilient in the last quarter of 2022. Consumer spending helped sustain growth, but we see signs of weakness beneath the surface. US PCE data showed that consumer spending was losing momentum at the end of the year and suggests that growth is slowing faster than expected.
The Fed and the European Central Bank are anchoring central bank decisions this week. We see both raising rates further and rejecting market expectations for rate cuts. US payroll and services PMI data will provide the latest insights into recession risks. We believe that more resilience in business and the labor market could provide some encouragement for the Fed.
This post originally appeared on iShares Market Insights.
This article was written by
Kurt Reiman is BlackRock's Chief Investment Strategist for Canada. Previously, Reiman served as BlackRock's Global Investment Strategist, where his responsibilities included liaising the investment strategy team's research with investment insights from leading institutional clients and financial advisors, and providing perspectives on all asset classes, including equities, fixed income, alternatives, and multi-sector approaches to investing. Mr. Reiman joined the firm in 2013 with over 15 years of experience in investment research and strategy. Prior to joining BlackRock, he was head of thematic research at UBS Wealth Management in Zurich and New York. Mr. Reiman also held analyst positions at Reuters and the G7 Group. Mr. Reiman holds a Bachelor of Business Administration from the State University of New York College at Plattsburgh and a Bachelor of Arts in International Relations with a concentration in International Economics from the Johns Hopkins University School of Advanced International Studies.
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