What the Fed’s hike means for markets

We see market complacency as a risk as the Federal Reserve normalizes its pace of normalization. Jeff explains.

The Federal Reserve’s (Fed’s) rate hike earlier this month marks a departure from the glacial pace of tightening in the past two years. By raising rates three months after the December 2016 hike, the central bank introduces the prospect of a more “normal” pace of rate rises, albeit one that is likely less rapid than in the past.

Fed policymakers have been pointing to a gradual path of two more rate rises in 2017—likely at the longer meetings that include a media conference. Markets look in line with this view, although some see three more hikes.

The central bank’s accelerated pace has occurred with little market disruption so far. Volatility across asset classes—including equities, credit, currencies and interest rates—stands near year-to-date lows. And yield spreads have remained tight—whether in U.S. high yield, hard-currency emerging-market (EM) debt or U.S. investment grade bonds. These elevated valuations may be a sign of market complacency. There is a much thinner yield cushion against the risk of rising interest rates than in the recent past. See the chart below.

BII-chart-valuation

The Fed’s hike in March is a signal of a gradual fading of a regime that encouraged investors to reach for yield—and take on more risk. As rates head higher, we should see a welcome respite from this environment. The prospect of rising yields on cash and government debt means investors could hit income targets while assuming less risk.

The challenge for investors will be to manage the transition as the Fed tightens. The central bank’s caution in only gradually raising rates is partly rooted in a desire to avoid a market selloff such as the “taper tantrum” in 2013 that occurred when the Fed signaled the beginning of the end of quantitative easing (QE). That caution also reflects structural reasons such as high debt levels, which constrain the global economy’s ability to weather rises in rates.

The Fed has thus far appeared more comfortable tightening by raising rates as opposed to signaling an intention to start unwinding its bloated balance sheet by halting the reinvestment of maturing security holdings. The difficulty for bond markets is that a rise in the relative attractiveness of risk-free assets comes at a time when the pricing of risky debt appears so rich. To be sure, any spikes in U.S. yields are likely to be suppressed by income investors fleeing still-rock-bottom interest rates in Europe and Japan.

Bottom line

The next stages in the Fed’s tightening cycle may become more volatile for financial markets, underpinning a defensive posture toward credit and my advice that investors be selective. I generally favor up-in-quality exposures and investment-grade bonds due to elevated valuations. Read more on this in my latest Fixed Income Strategy publication.

Jeffrey Rosenberg, Managing Director, is BlackRock’s Chief Investment Strategist for Fixed Income, and a regular contributor to The Blog.

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Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

Investing involves risks including possible loss of principal. Bond values fluctuate in price so the value of your investment can go down depending on market conditions. 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.

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 to adopt any investment strategy. The opinions expressed are as of March 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

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