Exposure rates of the Dorval Asset Management Range – September 16, 2022

Promising signs of disinflation continue, but persistently high core inflation is compelling the Fed to press forward in leaps and bounds. The yield curve is thus set to invert, sparking off expectations of a recession again…but the game is by no means over yet.

Producer price disinflation firmed up in August, alongside the drop in gasoline prices, which have continued to decrease into September. Regional manufacturing company surveys for September published so far suggest that this tendency is set to continue. However, the effects of this disinflation have not yet trickled through to consumer prices, with the core CPI still trending at around 6-7% (cf. chart 1). The ongoing increase in rents is one of the factors fueling persistently high inflation, although this should ease from the end of the year.

 

 

Producer price disinflation but consumer price inflation still too high
Annualized changes over 3 months, 3-month moving average

 

 

The rest of the US economy is still solid, as shown by very low new jobless claims: the financial markets have quite naturally concluded that the Fed would continue to stride ahead with its policy of massive steps, and some even expect a 100bps hike at the next FOMC meeting on September 21. At that point, the US yield curve will probably invert, with the 3-month rate moving above the 10-year yield (cf. chart 2). This 10-year/3-month differential is broadly seen as a harbinger of recession.

 

US Treasury bond yield curve will soon invert

10-year yield / 3-month rate
10-year – 3-month spread

 

However, some context should be given on the reliability of this indicator. Firstly, we must bear in mind the matter of timing: in the last five occurrences of a recession, the yield curve inverted between 10 and 22 months before the downturn (bar the slump triggered by Covid). The next recession in the US should therefore kick off between July 2023 and July 2024 judging by this “rule” derived from an obviously very small sample of recessions, which are rare events: we should not hold our breath. Additionally, historically very low interest rates make it more challenging to compare with previous episodes. Lastly, the yield curve is merely one of a range of leading indicators of a forthcoming recession, and other more traditional markers must also be considered, such as new orders, jobless claims, credit spreads, etc.

 

Despite the imminent inversion in the yield curve, the same challenges still remain for the months ahead. The slowdown in the world economy, the impact of rate hikes on real estate, the gradual normalization in production chains and the easing in commodities prices point to a scenario of moderation and disinflation that would likely be fairly good news for the financial markets. But for such times as inflation does not slow sufficiently, the central banks will continue to regularly pour cold water on investors’ hopes.

 

However, these same investors are finally beginning to better incorporate the central banks’ reaction function, and now expect the Fed to hike rates to 4.5% by March 2023, with 2.5% from the ECB (cf. chart 3). A more realistic approach is now beginning to prevail, and this could help stabilize the financial markets. However, we believe that the risk premium on bonds is still insufficient to venture onto these markets. Our strategy still remains firmly cash-oriented (very short-term negotiable debt securities) – interest rates are now in positive territory and rising – with a moderate-sized and extremely diversified equity compartment.

 

 

Short-term rate projections finally becoming slightly more realistic

Fed funds rate expected by the markets in March 2023
ECB rate expected by the markets in March 2023

 

 

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