A common topic among the fixed income crowd throughout 2014: When will the Federal Reserve raise interest rates? It’s a topic that gained persistence as 2015 drew near, and one the Fed didn’t necessarily help quiet with its noncommittal comments.
But perhaps, as Brad Tank, chief investment officer of fixed income at Neuberger Berman, and many other fixed incomes experts suggest, there are more interesting issues facing the fixed income markets in 2015.
“In some ways, the Fed is old news at this point,” Tank said in Neuberger Berman’s “Solving for 2015” outlook. “Whether it raises rates in June 2015 or the following January is not as interesting to the markets as whether the [European Central Bank] is on an effective path that prevents deflation.”
All Eyes on the ECB
Tank believes the beginning of 2015 will be critical for the ECB.
“Currently, you’ve got small-scale quantitative easing being embraced in Europe, but the market expectation is that ultimately you’ll need larger scale QE,” Tank said. “There are practical issues, such as what assets will work best for QE purchases, so it will take a long time to engineer. But it will be crucial in the first half of 2015 and everyone will be watching.”
Of those watching will be Rick Rieder, BlackRock’s chief investment officer of fixed income, fundamental portfolios, and co-head of Americas fixed income.
“As Europe continues to struggle, it raises the question of whether fiscal policy might be used to aid the recovery there, although there are significant political constraints that must be overcome with this,” Rieder wrote. “These limitations place the burden of economic recovery squarely on the European Central Bank, which is now taking a page from Japan’s playbook by suggesting that a significant quantitative easing program may be on the way in early-2015.”
Putnam Invesment fixed income experts – William Kohli, co-head of fixed income; Michael Salm, co-head of fixed income; and Paul Scanlon, co-head of fixed income – also believe more aggressive action will be needed.
“Deflation risk has increased in Europe, in our view, and the measures the ECB has taken thus far are not likely to prevent it,” they wrote in Putnam Investment’s Fixed Income outlook for 2015.
Meanwhile, Europe’s real economy continues to deteriorate.
“Our research shows that the eurozone is growing barely above a zero rate, only slightly better than the contraction we estimated in the summer months,” Kohli, Salm and Scanlon wrote. “Perhaps more importantly, this pickup is weaker than what was built into the European Central Bank’s (ECB) forecasts for the autumn.”
There is concern that the state of the eurozone would affect the U.S. rate outlook, as the Fed wants to be sure to avoid the mistakes of other central banks.
Putnam’s fixed income experts explained, “We are more worried about the eurozone today than we were just a few weeks ago, and we are more cautious about the U.S. rate outlook. Dimmer prospects for the global economy, not to mention second thoughts given substantially greater U.S. dollar strength, could cause the Fed to pause further into 2015 before it pulls its rate-raising lever.”
It’s clear to Rieder that the Fed wants to be sure to avoid the mistakes of other central banks.
“There is a certain caution inherent in the Federal Open Market Committee’s view of the world, since to move too soon and then have to reverse course would damage the central bank’s credibility, but the risks in moving a bit too late appear to be less of an issue for the Committee,” Rieder stated. “Thus, it could be said that the Fed is seeking to avoid the mistakes made by other central banks following the financial crisis and recession.”
An Unignorable Interest Rate Hike
Of course, the eventual rate rising can’t be ignored. With the Fed recently saying it will be “patient” on the timing of the first interest-rate increase since 2006, many fixed income experts are mixed on their rate hike predictions.
BlackRock’s Rieder points to one major fact that will lead the Fed to raise rates in 2015 – job growth.
“This fact suggests that the Fed may begin to raise policy rates sooner than markets have expected, and certainly it should not be later than mid-2015, in our view,” stated Rieder.
He cited the Bureau of Labor Statistics’ November nonfarm payroll print of 321,000 jobs gained, which he called “not only impressive at the headline level, but also displayed strength in its details.”
He said this data highlights “the positive momentum in U.S. labor markets.”
“The current run-rate in job creation is considerably stronger than the 200,000 average level of jobs growth typical of past periods of economic expansion,” Rieder stated, citing the three-month, six-month, and 12-month moving average nonfarm payroll gains of 278,000, 258,000 and 228,000, respectively.
Meanwhile, Putnam’s Kohli, Salm and Scanlon think the Fed may pause in its post-tapering plans to raise rates because of both dollar strength and global economic weakness.
“[W]hereas rising rates seemed on the horizon to us a few quarters ago, two developments make us more cautious about the policy outlook,” they wrote. “The first is the strength of the dollar. This does represent a modest tightening of monetary conditions.”
A strong U.S. dollar means cheaper imports; while good for households, it affects the corporate sector through trade competition and profit margins as well as pushes down on inflation.
“To the extent the weakness of other currencies reflects market doubts about growth prospects overseas, it is possible the Fed will start to worry about the economic prospects of its primary trading partners,” wrote Kohli, Salm and Scanlon. “We believe headline inflation will drop sharply in coming months, and the Fed could easily take this as a reason to be more cautious about rate policy.”
Neuberger Berman’s President and Chief Investment Officer Joseph Amato is also hesitant of the global economic effect on the U.S. interest rates.
“We are moving from a period in which policy across the developed world was aggressively accommodating, and quite synchronized in Europe, Japan and the U.S.,” Amato stated. “Now things are starting to diverge. The U.S. has begun to pull back, and we think rates will likely increase in the second half of next year or the first quarter of 2016. This transition contributes to sloppiness in the markets, which we’ve witnessed in 2014.”
Rieder thinks the Fed may be exaggerating the risks associated with what he calls a “generally sluggish global economy.”
“We think the Fed is overstating this risk, as the economy is in solid shape overall, and long-end yields will likely remain historically low given the ‘stock effect’ of the Fed’s balance sheet (creating a ‘shortage’ of Treasuries) and the gradual nature of the rate hikes that we anticipate,” wrote Rieder.
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