Rick Rieder, Chief Investment Officer of Fundamental Fixed Income at BlackRock, and Co-Manager of Fixed Income Global Opportunities (FIGO):
- As widely expected, the Fed continued policy rate normalization with a quarter-point hike, but while markets had priced the move in, and we think it’s reflective of a broader global policy evolution, there was a modestly hawkish tilt to Committee member rate projections for the years ahead.
- Overall, the hallmarks of this new policy and market regime are clearly reflation, inflation, and greater optimism that a more productive balance between growing fiscal and receding monetary policy stimulus can be found.
- As such, we think TIPS markets (breakevens) continue to look attractive and that risk markets are also likely to be well supported, rates can move moderately higher, inflationary expectations can continue to accelerate, and most importantly, economic and financial investment can and will grow alongside of this.
Yesterday’s Fed Hike Reinforces Shifting Global Policy Winds
As was widely expected by markets, the Federal Reserve’s Federal Open Market Committee (FOMC) hiked its federal funds policy rate by a quarter point. It’s been a year since the Fed inaugurated this hiking cycle in December 2015, and remarkably this is only the second rate adjustment since December 2008. We think U.S. policy rate normalization is long overdue, and more interestingly, we believe the move reinforces a broader global policy evolution, or regime change as we’ve referred to it elsewhere, involving a reduction in monetary policy influence and a turn toward fiscal initiatives. In the U.S., this policy evolution isn’t necessarily surprising, coming as it does after the economy has achieved a nearly historic 4.6% unemployment rate, with more than 15 million people hired since 2010 (for reference, this is a larger number than the populations of 46 states in the union, including Illinois, Michigan, and Wisconsin). What was somewhat surprising was the moderately hawkish tilt in Committee members’ year-end projections for the fed funds rate in 2017 (median of 1.375 vs. 1.125 in September), 2018 (2.125 vs. 1.875), and 2019 (2.875 vs. 2.625). Of course, this could well be the realization of reflationary potential being a bit stronger today than a few months back. Moreover, the reflationary impulse isn’t limited to the U.S. per se.
In fact, we would identify September 21 as just as critical a date of policy regime change, as on that day the Bank of Japan unexpectedly announced a shift away from its emphasis on negative policy rates and instead put forward a significant policy adjustment and plans to overshoot its 2% inflation target in an intentional manner. In our view, their intent is to modestly steepen the yield curve, helping to improve financial-sector profitability, which had suffered under the negative rate regime. Similarly, we think that the renewed interest in letting yield curves steepen, and engineer moderately, but not excessively, higher rate levels, was evidenced by the European Central Bank’s recent “non-taper taper,” although we have said the publicly, the ECB may have missed an opportunity for even bolder and more productive policy change. Ultimately, we think these specific directives toward steepening yield curves, and seeking a more productive equilibrium between monetary and fiscal policies should be beneficial to financial transmission mechanisms and consequently to re-rating growth and inflation higher in these regions.
Additionally, we think that it’s critical to understand that most developed market central banks are coming to believe that at this stage very low interest rates (especially negative rates) and flat yield curves for long periods of time hold little utility for supporting growth in the real economy, a point we have long argued for. The view that adequate and effective financial transmission is much, much, more important to the overall health of an economy, and particularly, to imbuing the system with higher levels of inflation is now coming into focus. In essence, we would point to our view that MV=PQ is still the fundamental principle in economic growth and inflation, and thus as M (the monetary base) grows, it doesn’t create any growth or inflation if velocity (V) shrinks due to impaired financial systems that struggle to build net interest margins, or capital, and thus are reluctant to lend and instead are focused on shrinking their businesses.
Yesterday’s move by the Fed, and the elevated changes in Committee members’ SEP rate forecasts balance alongside the idea that Chair Yellen has put forth of allowing the economy and inflation to run hotter for a time, in an attempt to heal the damage done by the financial crisis and recession (particularly with slow wage growth, now turning higher). In fact, the Committee specifically stated that “Market-based measures of inflation compensation have moved up considerably, but are still low…” indicating to us that they do not feel overshooting inflation is a concern for the time being. Thus, when placed in the context of policy rate normalization, and potentially significant fiscal stimulus from a U.S. government now unified under the Republican Party, we have to wonder if we have reached the end of a period that has been characterized by excessive central bank accommodation, financial repression, low growth, low inflation, low yields, and low terminal rate expectations. In other words, is the economic pessimism that has come to be thought of as our “normal” condition, in fact, overdone?
We think excessive pessimism is overdone, as the hallmarks of this new policy and market regime are clearly reflation, inflation, and greater optimism that a more productive balance between growing fiscal and receding monetary policy stimulus can be found. Of course, we would be the first to point out that this optimism has its limits, as structural changes to the country’s demographic profile and rapid technological change cannot be altered meaningfully. Still, within a range of “what is possible,” there are reasons to believe the new regime can run a bit, even with periodic retrenchments as markets get ahead of the facts on the ground. As a result, from an investment perspective, we think TIPS (breakevens) look much more attractive than nominal Treasuries at this stage.
Markets have been reacting to this policy regime change, even before the U.S. election kicked it into high-gear, and in addition to more traditional forms of fiscal policy stimulus (reduced taxes, and greater spending on infrastructure and defense, for example) a damping down of some of the inefficient regulation, while keeping thoughtful regulation, is the other positive catalyst for this improvement in financial transmission and velocity. In the end, we think central banks are now heading down more appropriate policy paths, and markets will continue to respond accordingly. That is to say that risk markets are likely to be well supported, rates can move moderately higher, inflationary expectations can continue to accelerate, and most importantly, economic and financial investment can and will grow alongside of this. That’s not to suggest that this progress won’t have setbacks, and other bouts of political risks could well jolt markets in the year ahead, but we believe alongside higher levels of volatility, markets will be encouraged by a more sensible policy mix that stands a better shot of improving growth prospects for a broader population.