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Here’s Why The Market Is Ignoring The Fed’s Interest Rate Hikes

From Invesco: The Federal Reserve (Fed) raised interest rates in March and is likely to raise them again twice this year, yet the financial markets have taken this news in stride. Why is this? Simply put, the Fed is behaving dovishly, considering the positive growth pattern we are seeing.

We are in the midst of a global growth pickup that began in the second half of last year. The three largest economic blocs — the US, Europe and China — are showing solid growth.1

  • In the US, a pickup in expectations and “animal spirits” due to the US election in November has boosted growth to above-trend levels.
  • In Europe, monetary stimulus has supported domestic growth, and the eurozone economy is now also growing above trend after lackluster performance in recent years.
  • The Chinese economy stabilized at the end of last year, and it too is showing upside growth momentum.

For the first time since the global financial crisis, we seem to be in the midst of a solid growth upswing among the world’s major economies.

Growth on its own is a positive for credit assets and risky assets such as equities, as their fundamentals are tied to the productive output of the economy in many ways. The potential negative is if policymakers tighten policy in response to this growth impetus and cause adjustments in asset prices.

Recent Fed statements appear to have reassured the markets

This is where the Fed’s recent statement and commentary are reassuring, in the view of Invesco Fixed Income. The Fed indicated that it is unlikely to aggressively tighten monetary policy soon. Indeed, in its March statement, it stressed the concept of symmetry around its inflation target. In other words, the Fed does not view its stated inflation target of 2% as a ceiling, but rather is willing to allow inflation to run higher than the target for an extended period. This implies that it will likely be patient in raising interest rates — and is unlikely to take the proverbial “punch bowl” away in the near term.

Likewise, we expect the European Central Bank (ECB) to be patient with its quantitative easing (QE) program as political risks remain in the eurozone. The Bank of Japan (BoJ) is committed to its Yield Curve Control (YCC) policy for the time being as well, in our view.

The bottom line: Improving growth combined with accommodating policymakers is good for most risky assets, in our view, and we have seen risky assets perform well, even as the Fed hikes rates.

Invesco Fixed Income’s view

Our macro factor framework — which provides the basis for much of our investment strategy work — seeks to understand the likely behavior of financial markets by isolating the impact that growth, inflation and financial conditions have on the markets. Currently, our view is that growth is showing upside momentum, inflation is well-contained, and financial conditions remain stable. Based on this, we expect to see upward pressure on global duration as real rates rise somewhat, relatively solid fundamentals for credit markets supported by growth, and a neutral view on the US dollar versus developed market currencies. Global growth is also supportive for emerging markets (EM) at the margin, so some EM currencies may see appreciation versus the dollar.

What could bring this rosy scenario to an end? At this point in the cycle, the primary risk would be an aggressive tightening of financial conditions. If central banks change their tune and become concerned about inflation, they could begin to tighten policy. That would change the picture and warrant caution on risky assets. But until they take the punch bowl away, we aim to stay long.

The iShares Barclays 20+ Yr Treas.Bond ETF (NASDAQ:TLT) closed at $120.71 on Friday, up $0.35 (+0.29%). Year-to-date, TLT has gained 1.33%, versus a 5.46% 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.

1 Sources: Bloomberg L.P., Invesco, data from June 30, 2016, to March 30, 2017

Important information

Blog header image: radiorio/

The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity.

Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.

The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

This article is brought to you courtesy of Invesco.

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