BlackRock warns on bonds as Fed officials say economy is sound

(Bloomberg) — BlackRock Inc., the world's largest asset manager, says bonds will "struggle" in 2016 as the Federal Reserve raises interest rates.

Two regional Fed bank presidents, Loretta Mester of Cleveland and John Williams of San Francisco, dismissed concern over stumbling stocks on the year's first trading day and said the economy was on solid ground. Futures trading indicates the Fed target will reach about 0.9 percent in a year, implying about two quarter-point rate increases by then, even with the latest turmoil from China.

"We also expect bonds to continue to struggle as interest rates drift higher on the back of Federal Reserve tightening and some stabilization in inflation expectations," Russ Koesterich, global chief investment strategist for New York-based BlackRock, wrote in a report Monday. The company has $4.5 trillion in assets.

The 10-year note yield rose two basis points, or 0.02 percentage point, to 2.26 percent as of 9:33 a.m. in New York, according to Bloomberg Bond Trader data. The price of the 2.25 percent note due in November 2025 fell 1/8, or $1.25 per $1,000 face amount, to 99 29/32. The yield will climb to about 2.75 percent by year-end, Koesterich said.

Treasuries returned 0.9 percent in 2015, while a gauge of global developed sovereign debt lost 2.5 percent, according to Bloomberg World Bond Indexes.

China Shares

Trading in China's CSI 300 Index of shares was halted Monday after the gauge slumped 7 percent, and shares dove worldwide. The gauge rose 0.3 percent Tuesday.

Longer-maturity Treasuries fell in New York morning trading Tuesday as major stock indexes gained.

"Underlying fundamentals of the U.S. economy remain very sound," the Fed's Mester said Monday in an interview on Bloomberg Television. "There's going to be volatility in the markets. That's kind of the nature of financial markets," said Mester, who votes on monetary policy this year.

Williams, who doesn't vote until 2018, also downplayed market turmoil, saying he expected unemployment to fall below the current level of 5 percent and inflation to begin moving back toward the Fed's 2 percent target this year.

'Good Shape'

"We are, relative to most other countries, in very good shape, partly because we took very aggressive monetary policy actions, and other actions, to get our economy back on track," Williams said in an interview on CNBC.

The Fed is less concerned about China and emerging economies than investors and may be too complacent, according to Philip Marey, a senior markets economist at Rabobank International, who forecasts the 10-year yield to rise to 2.55 percent this year.

"We expect an upward move in Treasury yields but nothing really substantial," said Marey, who's based in in Utrecht, Netherlands. "Not the type of thing you would expect with a tightening cycle."

Treasury two-year yields will rise as the Fed pushes rates higher, said Kim Youngsung, head of overseas investment at South Korea's Government Employees Pension Service in Seoul, which oversees the equivalent of $12.6 billion.

Long-Term Yields

"It's going to be a tough year for short-term interest rates," he said. "But long-term yields will be OK. There's heavy demand for long-term yields. We have uncertainty about the stock market. We just had a Chinese shock. That limited the increase in long-term interest rates."

The extra yield on 30-year bonds over two-year notes shrank to 188 basis points on Dec. 29, the narrowest since March. The difference was 198 basis points Tuesday.

Policy makers will raise their benchmark in four quarter- point steps in 2016, according to projections the central bank issued last month. They raised rates in December for the first time in almost a decade.

–With assistance from Lukanyo Mnyanda.

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