Jean Boivin together with Wei Li, Global Chief Investment Strategist, Alex Brazier, Deputy Head, Elga Bartsch, Head of Macro Research and, Scott Thiel, Chief Fixed Income Strategist all forming 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.
We see the sharp rise in government bond yields this year as consistent with a fundamental asset reallocation driven by investors wanting greater compensation for the risk of holding government bonds. The swiftness of these moves is an example of a market primed to overshoot amid confusion over the macro backdrop, as flagged in our 2022 Global Outlook. We slightly reduce our tactical underweight on U.S. Treasuries as a result, while keeping our strategic underweight unchanged.
Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and not subject to fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream, January 2022. Notes: The chart shows the number of 25 basis point rate to the end of 2024 across selected DM economies priced in currently vs. the number that were priced in November 2021. The hikes are calculated by comparing the average forward rate priced by the market in 2024 and comparing it to the current rate. We use the Secured Overnight Financing Rate in the U.S. and overnight index swaps for the rest.
Bonds have had a rough start to 2022 – extending last year’s unusually poor run. Yields are up sharply in the last month, as the chart shows. The short-end has surged because of a sharp pulling forward of policy rate hikes. Markets have rushed to price in faster and more aggressive Fed actions than we think is warranted. The rise in 10-year yields has largely been driven by a resurgence of the term premium, or the extra compensation investors demand for the risk of holding government bonds at still historically low yield levels. We have long had an underweight in U.S. Treasuries, so the recent market moves are playing out as we expected via a higher term premium – just much faster. Our base case remains that yields are headed higher on a one-year horizon, yet a short-term reversal has already started to unfold. On a strategic or long-term horizon, we still view the outlook for nominal government bonds as challenging and maintain our large underweight.
What’s striking is the speed of the yield spike. The Fed has effectively abandoned its prior guidance by suggesting it’s ready to start raising rates before achieving its “broad and inclusive” employment mandate. By doing so, it may have added to the confusion about the expected path of rates. Markets have quickly shifted their short-term expectations to include earlier and more rate hikes this year. The hawkish mood has spread to longer-term yields and to markets such as the euro area.
We trimmed risk heading into 2022 because we thought potential confusion over the macro backdrop could become a source of market stress. But cutting through the confusion – one of our 2022 Global outlook themes – is about recognizing that what matters is the cumulative rate hikes priced in over coming years, not their timing. That hasn’t changed and believe that’s right. How to cut through the confusion? We believe the key to making sense of the current environment is to recognize the cause of inflation: supply constraints. This marks a profound change from the decades-long dominance of demand drivers. We are in A world shaped by supply, where monetary policy cannot stabilize both inflation and growth: it has to choose between them. Central banks will be forced to live with more inflation, in our view, given the cost to growth of pushing down inflation. Understanding this shift in the economic landscape helps put the Fed’s pivot in context: it is taking its foot off the gas by starting to remove emergency stimulus – but this is a far cry from slamming on the policy brakes. We expect the transition to a more sustainable world to drive supply-triggered inflation far beyond the current economic restart. This is why we still see a historically muted policy response to inflation.
Our bottom line: Given the speed of the Fed repricing, bond markets may have gotten ahead of themselves in the short term. We reduce our tactical underweight to U.S. Treasuries as a result. But the backdrop for Treasuries remains negative as we see a further resurgence of the term premium pushing yields higher, especially as the Fed prepares to shrink its balance sheet. We don’t see this as necessarily bad news for equities. This year’s stock selloff hides huge shifts under the hood, with tech shares falling and many cyclicals eking out gains. We believe the narrative of “rates up, tech down” is too simplistic given the drivers behind the long-end bond selloff and the broadly unchanged, still-low sum total of expected rate hikes. Indeed, we believe fading Omicron fears have contributed to the tech selloff. We favor a barbell approach in our sector views. We like cyclicals as the powerful restart rolls on, and beyond a tactical horizon we still favor solid tech and healthcare stocks because we see them as beneficiaries of structural trends like digitalization and the transition to a net-zero world.
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 January 20, 2022. Notes: The two ends of the bars show the lowest and highest returns at any point over the last 12-months and the dots represent current 12-month 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, ICE U.S. Dollar Index (DXY), Bank of America Merrill Lynch Global High Yield Index, spot gold, J.P. Morgan EMBI Index, Refinitiv Datastream Italy 10-year benchmark government bond index, Bank of America Merrill Lynch Global Broad Corporate Index, Refinitiv Datastream Germany 10-year benchmark government bond index, Refinitiv Datastream U.S. 10-year benchmark government bond index and MSCI Emerging Markets Index.
The surge in long-term yields is part of what we see as a broader reallocation driven by the need for greater compensation for the risk of holding fixed income. That ultimately shouldn’t hurt risk assets, in our view. It’s early days still in the earnings season, but more than 75% of the 11% of the S&P 500 companies have beaten estimates. And growth expectations are being revised up as Omicron waves abate. We see inflation settling at a level higher than pre-COVID.
- Jan. 24 – Global flash purchasing managers’ indexes
- Jan. 25-26 – U.S. Federal Open Market Committee (FOMC) meeting
- Jan. 27 – U.S. GDP, Japan inflation data
- Jan. 28 – U.S PCE inflation and employment cost data
No policy change is expected at this week’s FOMC meeting, yet the meeting comes amid heightened market expectations of a sharp Fed rate hiking cycle starting as soon as March. The focus will be on what is actually driving Fed policy now that it has walked back on its previous guidance that meeting its “broad and inclusive” employment goal was a pre-cursor to lift off. Corporate earnings season sees about two-thirds of the S&P 500 – including big tech – reporting results the next two weeks.
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