From BlackRock: We see market complacency as a risk as the Federal Reserve normalizes its pace of normalization. Jeff Rosenberg explains.

The Federal Reserve’s (Fed’s) rate hike earlier this month marks a departure from the glacial pace of tightening in the past two years. By raising rates three months after the December 2016 hike, the central bank introduces the prospect of a more “normal” pace of rate rises, albeit one that is likely less rapid than in the past.

Fed policymakers have been pointing to a gradual path of two more rate rises in 2017—likely at the longer meetings that include a media conference. Markets look in line with this view, although some see three more hikes.

The central bank’s accelerated pace has occurred with little market disruption so far. Volatility across asset classes—including equities, credit, currencies and interest rates—stands near year-to-date lows. And yield spreads have remained tight—whether in U.S. high yield, hard-currency emerging-market (EM) debt or U.S. investment grade bonds. These elevated valuations may be a sign of market complacency. There is a much thinner yield cushion against the risk of rising interest rates than in the recent past. See the chart below.

The Fed’s hike in March is a signal of a gradual fading of a regime that encouraged investors to reach for yield—and take on more risk. As rates head higher, we should see a welcome respite from this environment. The prospect of rising yields on cash and government debt means investors could hit income targets while assuming less risk.

The challenge for investors will be to manage the transition as the Fed tightens. The central bank’s caution in only gradually raising rates is partly rooted in a desire to avoid a market selloff such as the “taper tantrum” in 2013 that occurred when the Fed signaled the beginning of the end of quantitative easing (QE). That caution also reflects structural reasons such as high debt levels, which constrain the global economy’s ability to weather rises in rates.

The Fed has thus far appeared more comfortable tightening by raising rates as opposed to signaling an intention to start unwinding its bloated balance sheet by halting the reinvestment of maturing security holdings. The difficulty for bond markets is that a rise in the relative attractiveness of risk-free assets comes at a time when the pricing of risky debt appears so rich. To be sure, any spikes in U.S. yields are likely to be suppressed by income investors fleeing still-rock-bottom interest rates in Europe and Japan.

Bottom line

The next stages in the Fed’s tightening cycle may become more volatile for financial markets, underpinning a defensive posture toward credit and my advice that investors be selective. I generally favor up-in-quality exposures and investment-grade bonds due to elevated valuations. Read more on this in my latest Fixed Income Strategy publication.

The iShares Barclays 20+ Year Treasury Bond ETF (NASDAQ:TLT) was unchanged in premarket trading Tuesday. Year-to-date, TLT has gained 1.93%, versus a 4.51% rise in the benchmark S&P 500 index during the same period.

TLT currently has an ETF Daily News SMART Grade of B (Buy), and is ranked #18 of 27 ETFs in the Government Bonds ETFs category.

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Jeffrey Rosenberg, Managing Director, is BlackRock’s Chief Investment Strategist for Fixed Income, and a regular contributor to The Blog.

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