Economic Barometer Rising
What About Interest Rates
Today, amid increasing signs that economic recovery is taking hold, there is growing concern that low interest rates (particularly with the Fed Funds rate holding at an all-time low of 0% to 0.25%) could spark a rapid rise in inflation, ultimately leading to higher long-term interest rates. We asked two BlackRock fixed income portfolio managers for their perspective.
Economy Holds the Key
Eric Pellicciaro, Managing Director and head of Global Rates Investments within BlackRock Fundamental Fixed Income, believes the key to the interest rate and inflation outlook lies in the economy. And that picture may not be exactly as it appears.
"Much of the recent increase in economic activity is the result of corporations realizing that the downturn was less severe than initially feared and that they may have been too aggressive in slashing costs," Mr. Pellicciaro explains. "As these firms are gradually increasing their production, investment and payrolls to bring them to levels consistent with a slow-growth economy rather than an economy in recession, it's creating the illusion of an economy that may be more vibrant than it actually is."
Indeed, the US economy continues to face significant headwinds, including high unemployment, tight lending standards and a housing sector struggling to recover. Mr. Pellicciaro expects growth figures in the second half of this year and into 2011 to disappoint relative to present-day expectations. "While we do not expect a double-dip recession, we also do not anticipate the high levels of growth that many are forecasting," he says. "It will still take households and businesses a considerable amount of time to finish repairing their balance sheets. This economic scenario holds the key in terms of our interest rate and inflation outlook."
Long-Term Rates to Drift Lower, Not Higher
Although rates remain quite low on a historical basis, yields at the long end of the Treasury curve have actually risen roughly 2% from their lows in 2008. Despite this dramatic move, the market is forecasting a continued rise in rates. For example, on May 3, the 1-year forward 10-year Treasury yield stood at 4.11%, 43 basis points (0.43%) higher than the spot (current) rate that day of 3.68%.
According to Brian Weinstein, head of BlackRock's inflation-linked strategies, "The market continues to be overly concerned about inflation and, therefore, is pushing forward yields higher. However, it is highly unlikely that the economy will be able to maintain its current moderate momentum if rates drift as high as the market is forecasting." If, as Mr. Weinstein anticipates, growth in the second half of the year comes in weaker than current projections, inflation expectations will diminish, leading to lower rather than higher long-term yields.
Of course, inflation will rise eventually, and Mr. Weinstein suggests investors be prepared by having some exposure to Treasury Inflation Protected Securities (TIPS). "These government-guaranteed bonds can offer valuable insurance against longer-term inflation because their principal and coupon payments are adjusted semiannually based on the prevailing inflation rate."
The Fed's Next Move
Mr. Pellicciaro believes that, "Under most scenarios, the Fed is unlikely to raise its target rate before the end of the year, particularly if economic activity falls below current estimates." He also expects the Fed to clearly telegraph its intentions in advance of its formal announcements. "Given the fragility of the system, we expect the Fed will be fully transparent so as to avoid suddenly disrupting markets."
* Archived articles are current as of the original date of publication.