LEMB - Bonds Are Our Top Choice If The Fed Keeps Rates 'Higher For Longer'

Summary

• The latest Fed rate hike is unlikely to be the last of this cycle. Furthermore, we believe those betting on Fed cuts in 2023 are likely to be disappointed.
• While down from 2022’s peak, we believe inflation readings are likely to remain elevated this year, preventing the Fed from easing - even if a recession takes hold.
• Investors can achieve yield targets at much lower levels of risk than in years past, underscoring the enhanced role that bonds can play in an investor's overall portfolio.
• We believe investors could use any backup in yields to get exposure to the kind of low-duration, high-quality fixed income bond found in the iShares 1-5 Year Investment Grade Corporate Bonds ETF (IGSB).

By Gargi Pal Chaudhuri

"Don't confuse a Fed pause with a Fed pivot" might not have the same ring as "Don't fight the Fed," but it could turn out to be key to investing in 2023.

After the FOMC's 25 basis point rate hike on Feb. 1, Wall Street's consensus is for the Fed to raise rates one more time by 25 basis points before reaching close to a peak for this cycle. ¹ That may prove correct, but we believe those betting on Fed cuts in 2023 - aka "a Fed pivot" - are likely to be disappointed.

While inflation seems to have peaked - and we expect will decrease further the coming months - our belief is it will likely remain far from the Fed's target of 2% by the end of 2023. In our view, elevated inflation readings are likely to prevent the Fed from easing this year, even if a recession takes hold. We think central bank authorities will ultimately raise the fed funds rate to 5.25%, and then hold rates in restrictive territory throughout 2023.

If this proves to be the case, the "risk on" trade that started last fall may prove to be short-lived. Against this backdrop, investors may want to consider taking shelter in investment grade credit, short-dated Treasuries, and stay in value and small-cap stocks, as detailed in our 2023 Year-Ahead Investor Guide . Overall, we continue to see the most opportunity in fixed income.

Bonds are back : While below its 2022 peak of around 4.35%, the 10-year U.S. Treasury note currently sits at 3.46%. Importantly, the 2-year U.S. Treasury bill is even higher - hovering around 4.20%. after starting 2022 at 0.80%. ² This means investors can now achieve yield targets at much lower levels of equity risk than in years past, underscoring the enhanced role that bonds can play in an investor's overall portfolio.

In a "higher for longer" environment, investors can earn a healthy coupon in high-quality fixed income without taking on too much interest rate risk at yield levels not seen since 2007. (See table below.)

We believe that investors may want to consider owning high-quality fixed income and use any backup in yields to add to exposure to the kind of low-duration, high-quality fixed income bond found in the iShares 1-5 Year Investment Grade Corporate Bonds ETF (IGSB). We also prefer the iShares MBS ETF (MBB) and iShares JP Morgan Local Currency Bond ETF (LEMB), given the targeted exposure available in those products. Our view is that the stabilizing dollar, peaking inflation and the Chinese reopening could be beneficial to owners of emerging markets in the near term.

Minimum fixed income required for a 6.5% yield

Why The Fed May Not Be Done Yet

While U.S. Consumer Price Index ((CPI)) inflation has decelerated from the 9.1% level seen this summer, it's still well above the Fed's 2% target. Overall CPI inflation was up 6.5% for the 12 months ending in December, while the core rate - which strips out food and energy - was up 5.7%.

Despite three-consecutive monthly drops in core CPI, we believe the market has become a bit too bullish about inflation returning to target, for the following reasons:

• Services inflation, which comprises 57% of CPI, was up 7% on an annualized basis for the 12 months ending December 2022. ³
• Shelter, the largest component of CPI, rose 7.5% in 2022, its strongest annualized rate since the 1980s. ³
• Core services, excluding shelter inflation, a data point that has been popularized recently by Fed Chairman Jay Powell, moved up to 0.21% in December vs. 0.15% in November and 0.19% in October. ³
• A handful of categories continue to drive inflation lower, including airfare, and new and used vehicles. Unfortunately, these are also often the most volatile categories. The stickier components such as shelter and medical costs continue to be high.
• Longer term, geopolitical tensions, deglobalization, and the impact of onshoring production can drive a secular boost to inflation.

Led by Fed Chair Jay Powell, numerous Fed officials have said they are prepared to leave rates 'higher for longer' in an effort to corral inflation - even if the economy continues to slow, potentially into a full-fledged recession.

"Restoring price stability when inflation is high can require measures that are not popular in the short term as we raise interest rates to slow the economy," Chair Powell said in a speech on Jan. 10. ⁴

Economic Growth In Focus

After investors fixated on inflation in 2022, we believe economic growth and the resilience of the labor market will be the top issues this year, and the growth trajectory is likely to be lumpy rather than smooth.

Notably, the equity rally that started last fall is vulnerable to weaker-than-expected economic data, as well as concerns about the U.S. debt ceiling.

Additionally, monetary policy often works with a lag, which academic studies suggest can last up to four years. ⁵

Because the Fed acted so aggressively last year - hiking rates by 425 basis points in the fastest tightening cycle since the 1980s - we believe further economic damage from 2022's rate hikes is almost certainly in the cards. Furthermore, "there is considerable uncertainty about how these policy lags will play out," as Atlanta Fed President Raphael Bostic writes. ⁶

The Federal Reserve may be on the sidelines for much of 2023, but investors will still have to deal with the fallout from last year's aggressive rate hikes. We may even get a "Fed-induced" recession, to cite another phrase entering the Wall Street lexicon. For more details on investing in a "higher for longer" rate environment amid slowing growth see our 2023 year-ahead investor guide .

© 2023 BlackRock, Inc. All rights reserved.

¹ CME Group as of Jan. 24, 2023. A basis point (bps) is one hundredth of one percent (e.g. one basis point = 0.01%).

² 2 Source: Bloomberg as of Jan. 24, 2023. Performance data represents past performance and does not guarantee future results.

³ Source: U.S. Bureau of Labor Statistics, Feb. 1, 2023.

⁴ Source: FederalReserve.gov . Jan 10, 2023. Panel on "Central Bank Independence and the Mandate - Evolving Views" at the Symposium on Central Bank Independence, Sveriges Riksbank, Stockholm, Sweden

⁵ Source: Bank for International Settlements, The lags of monetary policy (bis.org)

⁶ Source: Atlanta Fed, "On Long and Variable Lags in Monetary Policy," Nov. 15, 2022

Carefully consider the Funds' investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds' prospectuses or, if available, the summary prospectuses, which may be obtained by visiting the iShares Fund and BlackRock Fund prospectus pages. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in the value of debt securities. Credit risk refers to the possibility that the debt issuer will not be able to make principal and interest payments.

Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.

There may be less information on the financial condition of municipal issuers than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Some investors may be subject to federal or state income taxes or the Alternative Minimum Tax ((AMT)). Capital gains distributions, if any, are taxable.

An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency and its return and yield will fluctuate with market conditions.

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets or in concentrations of single countries.

Mortgage-backed securities ("MBS") and commercial mortgage-backed securities ("CMBS") are subject to prepayment and extension risk and therefore react differently to changes in interest rates than other bonds. Small movements in interest rates may quickly and significantly reduce the value of certain mortgage-backed securities.

Funds that concentrate investments in specific industries, sectors, markets or asset classes may underperform or be more volatile than other industries, sectors, markets or asset classes and than the general securities market.

Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Index performance does not represent actual Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com.

This material represents an assessment of the market environment as of the date indicated; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision.

This material contains general information only and does not take into account an individual's financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial professional before making an investment decision.

The information provided is not intended to be tax advice. Investors should be urged to consult their tax professionals or financial professionals for more information regarding their specific tax situations.

The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, "BlackRock").

The iShares Funds are not sponsored, endorsed, issued, sold or promoted by Bloomberg, BlackRock Index Services, LLC, Cboe Global Indices, LLC, Cohen & Steers, European Public Real Estate Association ("EPRA® "), FTSE International Limited ("FTSE"), ICE Data Indices, LLC, NSE Indices Ltd, JPMorgan, JPX Group, London Stock Exchange Group ("LSEG"), MSCI Inc., Markit Indices Limited, Morningstar, Inc., Nasdaq, Inc., National Association of Real Estate Investment Trusts ("NAREIT"), Nikkei, Inc., Russell, S&P Dow Jones Indices LLC or STOXX Ltd. None of these companies make any representation regarding the advisability of investing in the Funds. With the exception of BlackRock Index Services, LLC, who is an affiliate, BlackRock Investments, LLC is not affiliated with the companies listed above.

Neither FTSE, LSEG, nor NAREIT makes any warranty regarding the FTSE Nareit Equity REITS Index, FTSE Nareit All Residential Capped Index or FTSE Nareit All Mortgage Capped Index. Neither FTSE, EPRA, LSEG, nor NAREIT makes any warranty regarding the FTSE EPRA Nareit Developed ex-U.S. Index, FTSE EPRA Nareit Developed Green Target Index or FTSE EPRA Nareit Global REITs Index. "FTSE®" is a trademark of London Stock Exchange Group companies and is used by FTSE under license.

©2023 BlackRock, Inc or its affiliates. All Rights Reserved. BLACKROCK, iSHARES, iBONDS, ALADDIN and the iShares Core Graphic are trademarks of BlackRock, Inc. or its affiliates. All other trademarks are those of their respective owners.

iCRMH0223U/S-2696081

This post originally appeared on the iShares Market Insights.

For further details see: