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BlackRock Commentary: Mind the (rate expectation) gap

Jean Boivin, Head of the BlackRock Investment Institute together with Wei Li, Global Chief Investment Strategist, Elga Bartsch, Head of Macro Research, and Scott Thiel, Chief Fixed Income Strategist, all part of the BlackRock Investment Institute, share their insights on global economy, markets and geopolitics. Their views are theirs alone and are not intended to be construed as investment advice.


Markets are pricing in a liftoff from near-zero policy rates as early as next year, even though the Fed through its new framework has committed to stay behind the curve on inflation. We caution against extrapolating too much from strong near-term activity data amid a powerful restart. We see a high bar for the Fed to change its policy stance and believe this may be underappreciated by markets.

Article Image 1 Mind the (rate expectation) gap 11-05

Forward looking estimates may not come to pass. Sources: BlackRock Investment Institute, Federal Reserve and Federal Reserve Bank of New York, with data from Refinitiv Datastream, May 2021. Notes: The chart shows expectations for the federal funds rate, the Fed’s policy target. Market pricing is based on futures on the U.S. dollar Secured Overnight Financing Rate. We use the median forecast in the March 2021 Survey of Market Participants by the New York Fed. The BII assumption is part of our economic projections in our capital market assumptions. The Fed median dot plot comes from the January 2021 Summary of Economic Projections.

 

The Fed has reiterated its intention to stay behind the curve on inflation under its new framework that implies inflation overshoots to make up for past misses. Yet this has been met with some skepticism in markets, against the backdrop of a powerful economic restart. Current market pricing and consensus expectations suggest the federal funds rate, the Fed’s policy rate, would start rising much sooner than Fed officials’ own projections would indicate. See the chart above. We see two reasons for this disconnect. First, investors may be over-extrapolating from near-term growth data amid the powerful economic restart. We view the Covid shock as more akin to a natural disaster followed by a rapid “restart” – instead of a traditional business cycle recession followed by a “recovery.” That implies the huge near-term growth spurt will be transitory. And second, we believe many are still wedded to the central bank’s old policy framework, and may underestimate the central bank’s commitment to push inflation above target.

Market chatter about a potential tapering of the Fed’s asset purchases has gotten louder, yet we don’t see the Fed discussing this imminently. Tapering is the first step towards normalization of Fed policy, but even a discussion later this year does not mean the liftoff is close. There is a risk the discussion could trigger market volatility or be miscommunicated by the Fed. We believe investors should look through any such bouts of volatility, as our new nominal theme implies that the Fed will likely be much slower than in the past to raise rates in the face of rising inflation.

Inflation – not the near-term growth outlook – is key to the Fed’s rate outlook under the new framework, in our view. We believe two important developments would need to take place before the Fed considers a liftoff. First, the realized core personal consumption expenditures (PCE) price index, the Fed’s preferred inflation gauge, should stay at or around the Fed’s 2% target for a sustained period of time. The current inflation overshoot doesn’t meet the bar as the Fed views it as driven by transient factors. We also see uncertainties around the near-term persistence of the overshoot as the restart has led to unusual supply and demand dynamics. This is why we have recently closed our overweight in inflation-linked bonds over the tactical horizon. Second, the Fed’s inflation forecast would need to rise from current levels and point to a prolonged period of moderately above-target inflation. What could potentially pull forward the Fed’s timetable for a liftoff? An upward spiral in prices and wages set in motion by behavior of individuals and firms could be one driver, in our view.

The bottom line: The Fed is in the process of building credibility in the framework and has set a high bar to change its easy policy stance, even in the face of higher realized inflation. This implies that eye-popping growth numbers in coming months will be largely irrelevant to its rate outlook – and the restart momentum shouldn’t be over-extrapolated, in our view. The implication: stay invested as the restart broadens out. We are still pro-risk, but the support for this stance has shifted from our expectation for the restart to surprise to the upside to our belief markets are underappreciating the Fed’s commitment to its new framework. Risks to this view include market overreaction to the near-term growth rebound and worsening virus dynamics. We believe the near-term spike in inflation is barely making a dent in the cumulative inflation shortfalls after many years of misses, and expect medium-term inflation to gradually rise. Over the strategic horizon, we are underweight nominal government bonds and prefer inflation-linked bonds.

Market Updates

Article Image 2 Mind the (rate expectation) gap 11-05

Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream as of May 6, 2021. Notes: The two ends of the bars show the lowest and highest returns at any point this year to date, and the dots represent current year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in U.S. dollars, and the rest in local currencies. Indexes or prices used are, in descending order: spot Brent crude, MSCI Europe Index, MSCI USA Index, MSCI Emerging Markets Index, Bank of America Merrill Lynch Global High Yield Index, ICE U.S. Dollar Index (DXY), Bank of America Merrill Lynch Global Broad Corporate Index, J.P. Morgan EMBI index, Refinitiv Datastream Italy 10-year benchmark government bond index, Refinitiv Datastream Germany 10-year benchmark government bond index, Refinitiv Datastream, spot gold and U.S. 10-year benchmark government bond index.

Market backdrop

U.S. nonfarm payrolls growth was much slower than expected in April. We believe the market is too aggressive in its pricing of a policy rate lift-off in the U.S. and don’t think near-term growth or employment data will likely affect the Fed’s rate policy outlook. U.S. stocks hit record highs. Among nearly 90% of S&P 500 companies that have reported first-quarter earnings, 87% have beaten estimates, Refinitiv data showed.

Week Ahead

  • May 9-16  – China total social financing and new yuan loans
  • May 11 – German ZEW economic sentiment
  • May 14- U.S. retail sales, University of Michigan Surveys of Consumers

China’s lending data will be in focus this week. We expect China’s total social financing data – the broadest measure of liquidity supply to the real economy – to be broadly stable. in line with goals of policymakers. U.S. retail sales data – as well as the University of Michigan sentiment survey – should shed light on the restart of consumer sector as more states are lifting virus restrictions.


BlackRock’s Key risks & Disclaimers:

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 May 10th, 2021 and may change. The information and opinions are derived from proprietary and non-proprietary 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 material 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 material is at the sole discretion of the reader.

The information provided here is neither tax nor legal advice. Investors should speak to their tax professional for specific information regarding their tax situation. Investment involves risk including possible loss of principal. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation, and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets. 

Issued by BlackRock Investment Management (UK) Limited, authorized and regulated by the Financial Conduct Authority. Registered office: 12 Throgmorton Avenue, London, EC2N 2DL.


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