BlackRock’s Weekly Market Commentary: Rate hikes: Sum total is key, not timing

By the BlackRock Investment Institute

The year is off to a rocky start, with a jump in 10-year Treasury yields and a swoon in tech shares pulling down stocks. The culprit? Markets believe the Fed will raise rates sooner and more aggressively than expected. That’s not the story, in our view. The sum total of expected rate hikes remains low, thanks to a historically muted Fed response to inflation. Instead, the yield spike tells us that investors are less willing to pay a safety premium for bonds – and isn’t bad news for stocks per se.

Chart of the week

U.S. 10-year Treasury yield drivers, 2020-21

The plunge in global government bond prices at the start of this year underscores the new market regime highlighted in our 2022 Global Outlook. The trigger was the Fed indicating a faster-than-expected policy normalisation, including speeding up the timeline for letting its bond portfolio shrink. Markets quickly priced in faster and more rate hikes this year against a backdrop of 40-year high inflation and a tight labor market. Equities have come under pressure as growth stocks lost some of their luster with the apparent prospect of higher interest rates making future earnings less attractive. Is all of this bad for equities? We don’t think so.

What really matters for stocks, in our view, is that the Fed has kept signaling a low sum total of rate hikes. That hasn’t changed. Indeed, expectations for the future fed funds rate (the yellow line in the chart) have risen only modestly in the last six weeks, whereas 10-year Treasury yields have shot up (the green line). The driver instead is an increase in the term premium (the red line), the extra compensation investors demand for the risk of holding government bonds at historically low yield levels.

Understanding the drivers behind both the Fed’s muted response and the yield spike are key to navigating this environment. The Fed has adopted new policies that let inflation run a little hot to make up for below-target inflation in the past – and has now met its target. We believe the Fed and other central banks will want to keep living with inflation. Why? Today’s inflation is triggered by pandemic-induced supply constraints, a sea change from decades of demand-driven price pressures.

Our upcoming Macro and market perspectives will explain why this matters: Tightening would only serve to hurt growth and employment at a time when the economy has not yet reached full capacity. Central banks are merely lifting their foot from the gas pedal by starting to remove emergency stimulus released when the pandemic hit in 2020, in our view. This muted response should only modestly increase historically low real, or inflation-adjusted, yields and underpin equity valuations.

The recent yield spike ostensibly has echoes of 2013’s “taper tantrum” when the Fed then flagged a reduction of bond purchases. Yet we see key differences: It’s not driven by fears of a sharp increase in the policy rate; growth is strong; and the Fed has honed its signaling. The Fed’s planned reduction of its balance could result in investors demanding a higher term premium for holding long-term bonds – but this need not be negative for equities in contrast to the taper tantrum, in our view. So far the Fed’s pivot on policy matters less for medium-term investors focused on the cumulative policy response.

We see three main risks. First and foremost: Central banks actually hit the brakes or markets think they might – a bad outcome for both stocks and bonds and one of the alternative scenarios to our base case laid out in our 2022 Global Outlook . We also considered the possibility of a sharper rise in the term premium relative to our base case for a more gradual increase depending on how the Fed handles the shrinking of its balance sheet. Second, we believe the Omicron strain presents downside risks to China’s growth outlook, especially given the influx of visitors for the Winter Olympics.

We expect the country to maintain its zero-COVID policy – at least optically – in this politically important year. This heralds more restrictions on activity, even as Beijing appears bent on achieving its growth target this year by loosening policy. Third, we see potential conflict risks surrounding Iran’s nuclear ambitions, Russia’s massing of troops near Ukraine and, to a much lesser extent, Taiwan. These could rattle investors at a time the market’s attention to geopolitics is low. See our geopolitical risk dashboard.

Our bottom line: We prefer equities in the inflationary backdrop of the strong restart of economic activity. We favour developed market stocks as we dial down risk slightly and are underweight government bonds.