Investors are reassessing their expectations regarding when the Federal Reserve may begin lowering interest rates, as the challenge of bringing down inflation persists, according to Rick Rieder, Chief Investment Officer of Global Fixed Income and Head of the Global Allocation Investment Team at BlackRock, the world’s largest asset manager.
As the Federal Reserve’s two-day policy meeting unfolds, some Fed officials may hesitate to cut rates due to signs of persistent inflation in the services sector of the U.S. economy. Rieder believes that Fed Chair Jerome Powell will likely suggest that rate cuts are still feasible and may indicate June as a probable timeframe to commence such actions. Powell may express a willingness to reduce the central bank’s benchmark rate this year, considering the distance from equilibrium or a normalized rate after the recent tightening of monetary policy to address inflationary pressures.
While market expectations suggest that the Fed will maintain its benchmark rate at the current 22-year high, traders in the federal-funds-futures market indicate a 56% probability of rate reductions starting as early as June, according to the CME FedWatch Tool. Traders anticipate approximately three rate cuts of a quarter percentage point each in 2024, with the likelihood of fewer cuts slightly outweighing the probability of more than three by year-end.
Investor anticipation is high for the Fed’s release of its summary of economic projections, which will offer insights into whether inflation concerns have influenced the number of rate cuts officials are projecting for the year. Rieder suggests that projections for only two rate cuts in 2024 could disappoint markets, with a 25% to 30% chance of such a forecast from the Fed.
Additionally, Rieder highlights the importance of examining the summary of economic projections regarding the longer-run fed-funds rate, which has previously been estimated at 2.5%. There is a possibility that this estimate could be revised higher, signaling higher interest rates for an extended period.
The Fed has maintained its current policy rate at a target range of 5.25% to 5.5%, significantly above its longer-run projections, in an effort to curb inflation and steer it towards the 2% target.
Inflation, measured by the consumer-price index, rose by 0.4% in February, resulting in a year-over-year rate of 3.2%, as reported by the Bureau of Labor Statistics last week. Core inflation, which excludes volatile food and energy prices, also increased by 0.4% last month, leading to an annual pace of 3.8%.
The Federal Reserve’s preferred gauge of inflation, the core data from the personal-consumption-expenditures price index, is set to be released on March 29. In January, core PCE data showed a rise in inflation, but it eased to 2.8% year over year.
Rick Rieder, Chief Investment Officer of Global Fixed Income at BlackRock, highlights the persistently high service-level inflation, contrasting it with goods inflation, which is experiencing negative rates due to the Fed’s aggressive monetary tightening. Rieder expresses concern that the Fed’s higher interest rates are placing pressure on lower-income borrowers, local banks, and commercial real estate.
The impact of the Fed’s rate hikes is being felt by cash-strapped consumers with lower incomes, who are facing challenges with increased borrowing costs resulting from tighter monetary policy. This sentiment was echoed by Todd Vasos, CEO of discount retailer Dollar General Corp., who stated that customers are feeling the effects of inflation over the past two years, prompting them to make tradeoffs in their spending at the store.
Additionally, there is pressure on local banks, exemplified by the decline in shares of troubled New York Community Bancorp Inc. in January and February. The situation prompted the bank to secure a $1 billion equity investment, led by former Treasury Secretary Steven Mnuchin’s investment firm, Liberty Strategic Capital.
‘Undue pressure’
Rick Rieder points out that interest rate increases by the Federal Reserve have historically had a broader cooling effect on the U.S. economy. However, the shift towards a more services-oriented economy, as opposed to one focused on manufacturing, has altered this dynamic. As a result, the Fed may need to consider more extreme measures to achieve the desired impact of higher rates, potentially putting undue pressure on sectors of the economy that are more sensitive to rate changes.
The composition of the U.S. stock market, particularly the S&P 500, has also changed. The index is heavily weighted towards Big Tech companies, which have ample cash reserves to fund their growth and are less reliant on borrowing. Consequently, the stock market has become less sensitive to rate hikes.
Despite rising Treasury yields this year, the S&P 500 has posted significant gains, driven primarily by the performance of megacap Big Tech companies such as Nvidia Corp., Meta Platforms Inc., Amazon.com Inc., and Microsoft Corp.
Rieder, as the lead portfolio manager for the BlackRock Flexible Income exchange-traded fund, has been seeking higher yields globally, particularly in areas such as high-yield corporate credit and securitized debt. The actively managed fund has an annual yield of around 6.6%, outperforming the broader market for U.S. investment-grade debt.
Although credit spreads may not be as attractive as in the past, Rieder emphasizes that credit quality remains strong, making credit investments still appealing despite narrower spreads.