Rick Rieder, Chief Investment Officer of Fundamental Fixed Income chez BlackRock, et Co-Manager of Fixed Income Global Opportunities (FIGO)
- As expected, the FOMC raised its policy rate range today, and the communication from the Committee underscored its building confidence in the continuation of economic strength, due in part to current and impending fiscal stimulus.
- Ultimately, we believe policy normalization is less about the speed at which the Fed moves, and more about how long the Committee will be willing to raise rates, as underscored by the Committee’s upgraded view of labor markets and inflation.
- Finally, this policy path holds some significant implications for rate markets, as longer duration (interest-rate sensitive) assets need to be handled with care, as only small rate moves can exhibit large hits to principal in these parts of the markets, as evidenced already this year.
Does Today’s FOMC Meeting Represent a New Stage in Fed Action?
Today’s announcement by the Federal Reserve’s Federal Open Market Committee, including a policy rate hike, clearly represents the central bank’s building confidence in the continuation of economic strength, and as Chair Powell described in his Humphrey-Hawkins testimony, a greater level of confidence due to current and impending fiscal stimulus. Indeed, today’s statement, press conference and policy move were a direct attempt at threading the needle between displaying confidence in the economy’s prospects and also reflecting the desire not to disrupt an economy that is growing consistent with Fed goals, but is still not overheating from an inflation perspective, or even close to doing so.
The Fed’s nod to moderate, yet genuine, acceleration of inflation growth places markets on watch for continued normalization of policy. We believe that this effort is less about the speed at which the Fed moves, and more about how long the Committee will be willing to raise rates, and to what ultimate destination point. In our view, the market has rightly assumed three to four rate hikes this year, with consensus having now moved to four hikes. Still, the data will determine ultimately what that answer is. Often, the markets appear to assume that the Summary of Economic Projections (known colloquially as the dotplot) is written in stone. Yet we think the SEP is better viewed as an attempted guide to current Committee-member thinking, and as such it will evolve over time, similarly to how it did prior to last year.
We believe that the Fed’s communication today gave confirmation that it would take quite a lot to move the central bank from a three rate hike path for 2018. Additionally, we think the Fed is clearly signaling to market participants that pricing in 1.5 hikes in 2019 and 0.25 hikes in 2020, prior to this afternoon’s release and press conference, was not in fact in sync with where the Fed mindset on policy currently resides. Therefore, we think we’re likely to see something closer to three hikes in 2019 as well, and maybe a couple incremental hikes in 2020, depending on economic and financial conditions at that time. Thus, markets should view today’s communication as a guide to current thinking and should believe that the Fed’s commitment to longer-term normalization efforts will be greatly influenced by the data over the coming months. Ultimately, there is dramatically more “information value” to be had from the Fed’s prognosis of the current economic situation, and that of the next couple of quarters, than anything significantly longer than that.
From an investment standpoint, we think that this Fed will not be excessively focused on the speed of normalization, but rather will place an emphasis on its duration. Thus, we think that investing in shorter-term interest rates provides a much greater degree of certainty and lower volatility, while still capturing most of the yield available in the entire yield curve today. In a rising rate environment, while the shape of the curve is interesting, a higher premium should be placed on protection of principal in rate markets. And while the curve could flatten somewhat further after today’s announcement, and holding some longer duration makes sense in a well-balanced portfolio, the Fed’s clear confidence in economic conditions suggests that it would take a good deal to shake the central bank from its rate normalization process.
Given that fact, longer duration (interest-rate sensitive) assets need to be handled with care, as only small rate moves can exhibit large hits to principal in these parts of the markets, as evidenced already this year. In fact, the Bloomberg Barclays U.S. Aggregate index is down 2.17% so far this year, with the 7-10-Year U.S. Treasury segment having moved down 252 basis points alongside this. Yet, this doesn’t tell much of the story, since the 1-3 year sector of the Aggregate index is only down 39 bps, while the 25+ year part of that index is down 537 bps, displaying the risk we’ve seen at the long end of the curve. While many like to chronicle small movements in the shape of the curve, we think that rate, and consequently risk, markets will be extremely sensitive to losses in fixed income portfolios, and the higher discount rate on risky assets, simultaneously.
In our estimation, the new Fed Chair and Committee are properly reacting to a growing and moderately inflating economy, in which financial conditions have been too easy. Every attempt will be made not to upset that delicately-balanced apple cart of economic and financial conditions too greatly, but the Fed has made it very clear that the apple cart is being held up too aggressively by the support-legs of monetary policy. Now, those support legs will have to be replaced by the market’s willingness to take risk in the absence of any actual or perceived central bank put: that is indeed a new era. Of course, this new stage has already been ushered in cautiously over the course of 2017, but now it is a stance that will be carried through with a growing sense of confidence and conviction by this new (and still to be determined) group of central bankers led by Chair Powell.