BlackRock strategists say traders are wrong about Fed’s path
Strategists from the world’s biggest asset manager are challenging traders betting that the Federal Reserve will raise rates to around 3% next year, saying that policymakers will raise borrowing costs to 2%, but not go much further.
An overly aggressive path of hikes to combat the spiraling cost of living may backfire, according to the BlackRock Investment Institute, which estimates that bringing inflation down last year to the Fed’s target of 2% could have pushed unemployment to nearly 10%, based on the historical relationship between inflation and employment.
That’s unlikely to be a scenario that the Fed wants, and means it will eventually “choose to live with inflation,” said Alex Brazier, the deputy head of the institute, noting that inflation is currently being driven more by supply constraints than demand.
Data this week showed that U.S. consumer prices rose by 8.5% in March, the most since 1981. That gauge has historically run about 40 basis points above the Fed’s preferred inflation measure which its policy target is based on.
BlackRock’s view that the Fed will live with inflation underlines its underweight position on bonds. The strategists see the so-called neutral rate – a level that neither stimulates nor curbs the economy – at around 2%-2.5%, partly due to the assumption that price growth will soon peak and gradually ease.
The asset manager expects inflation to settle at around 3%, which is still higher than the Fed’s target and its 10-year average. It didn’t provide a specific time frame for the forecast.
While Fed officials mull where their long-term neutral policy rate might be, money markets were recently pricing rates rising to as high as 3.2% next year, and Goldman Sachs. Chief Economist Jan Hatzius said last week that the Fed may need to bump rates to over 4%.
“The market is now pricing in a scenario where central banks won’t just normalize rates – it assumes they will go further and hit the monetary brake,” Brazier said. “That is far from certain because the nature of this inflation is that it’s supply driven.”
Brazier said the Fed’s latest projections confirmed a view that they are not prepared to destroy demand or jobs in order to bring down inflation. While the central bank revised up its inflation forecasts, it kept the unemployment rate steady at around 3.5%, and growth above trend.
Fears of aggressive tightening by the Fed – which last month kicked off what’s expected to be a series of interest rate hikes – have triggered a sell-off in bonds, especially at the front end, causing the yield curve to briefly invert earlier this month. An inversion is often seen as a warning sign as it suggests the market assumes the Fed will raise rates so much that it kills inflation, and economic growth, down the road.
The latest price moves in bonds have helped to steepen the curve a bit, with the yield spread between 2- and 10-year notes rising to 34 basis points from minus 8 basis points at the start of the month. The gap, known as term premium, may have further to go as the market adjusts to the Fed’s policy trade off, said Brazier.
“Choosing to fight inflation would raise the risk of a recession, while living with inflation would mean more persistent inflation. The market is pricing some probability of the Fed fighting inflation rather than living with inflation,” Brazier said.
Separate strategists at BlackRock said in a report today that they are turning even more positive on U.S. and other developed-market equities, with a gradual normalization in monetary policy unlikely to be a major headwind in the second quarter.
Washington Post News Service (DC)
4/14/2022 11:21:21 AM Central Daylight Time