Is More Rate Volatility On The Horizon?

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Includes: BASIX, BSICX, BSIIX, DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: BlackRock
Summary

Strong data has been supportive of the Fed’s path toward normal rates, but geopolitical risks could make some waves.

Inflation expectations still play a role in the Federal Reserve’s monetary policy decisions.

We have long argued the importance of secular trends that will drive markets over time.

Inflation data released in June point to a continuation of gradually firming inflation in the United States. The Core Consumer Price Index (CPI) increased 0.2%, bringing core inflation to 2.2% year-over-year in May. While it is clear that general prices are firming, we are cautious of placing too much weight on a single data point. We have long argued the importance of secular trends that will drive markets over time, and we believe demographics and technology will likely keep inflation contained in the long run.

That said, inflation expectations still play a role in the Federal Reserve’s monetary policy decisions; and this recent data, along with revised projections for higher growth and lower unemployment in the near term, contributed to the Fed’s June 13 decision to raise the Federal Funds rate by 25 basis points (0.25%), bringing the target range to 1.75-2.00%.

This decision was widely anticipated given the continued strength in U.S. data, but we think the Fed could be facing some challenges in maintaining its expected path toward normalized rates amid rising geopolitical uncertainty. Notably, depending on how the global trade situation unfolds, the Fed could be forced to hit the pause button or even reverse course.

We continue to think that the front end of the yield curve offers attractive value given higher short-term yields, while we anticipate that longer-term interest rates can still move moderately higher this year. If the Fed deviates from its expected path, we could see more volatility in interest-rate-sensitive markets. This ongoing dynamic underscores that fixed-income investors have to be selective not only about how much they own, but what they own.

Outperformance with lower volatility

Outperformance with lower volatility chart

Source: Morningstar as of 5/31/18. Returns are from 5/31/17 through 5/31/18. Volatility is measured from 5/31/17 through 5/31/18 using daily returns. For standardized performance of the BlackRock Strategic Income Opportunities Fund, click here.

In the Strategic Income Opportunities Fund, we hold the majority of duration in the 0- to 2-year part of the yield curve, but we also hold exposure in the 7- to 10-year space as we believe rates are hovering around the highs of their near-term range. We slightly reduced the fund’s inflation protection positions (in breakeven form) as the market’s expectations for future inflation have become more aligned with our view.

We increased the fund’s allocation to investment grade credit on the front end of the curve and continue to hold high-quality names for income generation. Within emerging markets, a stronger U.S. dollar and global trade tensions are creating a headwind for the sector. Although we reduced the fund’s overall EM exposure, we continue to hold select positions in China, Argentina and Mexico.

Article was originally on BlackRock.com

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