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 U.S., Europe and China – are showing solid growth.1
- In the U.S., a pickup in expectations and “animal spirits” due to the U.S. 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 most 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 U.S. 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.