Exposure rates of the Dorval Asset Management Range – September 26, 2022

Jerome Powell’s doggedly determined “whatever it takes” approach in the battle against inflation has triggered a fresh sell-off on the financial markets. Meanwhile, the prevailing sense of panic in Europe and the UK has added fuel to the fire. Will interest rate projections soon be adequately recalibrated?

Despite signs of burgeoning disinflation and the anchoring of household inflation projections (cf. chart 1), the Fed decided to crank up the pressure at its meeting on September 21, still determined to leave no room for complacency for such times as inflation remains above its 2% target. By way of reminder, the figure hit around 6% this summer. A rebalancing on the labor market – and hence a sharp economic slowdown – will be required to achieve this goal. However, the latest available employment and economic activity statistics attest to resilience and suggest that there is still quite some way to go.



Fed decided to ignore the easing in inflation projections
Fed funds rate vs. household inflation expectations (New York Fed survey)

Inflation expected by households in 3 years / Rates projected by the Fed in 2023 / Inflation expected in 5 years / Fed funds rate



As we have often said this year, market operators have never truly believed that the Fed’s reaction function could change to such an extent in comparison with previous decades. This relative complacency was discernible first and foremost on the bond market, which priced in the notion of a fairly swift return to 2% inflation without the Fed needing to move its rates above 3-3.5%. However, the situation has now shifted considerably, with investors expecting the Fed to hike rates to 4.75% by the Spring, in line with the central bank’s latest projections, and around 1.5 percentage points above 2023 inflation projections (cf. chart 2). These rates could even be further upgraded, depending on forthcoming inflation, jobless numbers and wage data. The risk/return profile on the US bond markets may therefore not yet be sufficiently attractive at this stage: the same can also be said of the long end of the yield curve, where the term premium remains subdued, with long-term yields still shy of 4%. 



Market operators now expect Fed funds to far outstrip inflation in 2023

Fed funds rate expected by the markets in May 2023 / Bloomberg consensus on US inflation in 2023 (PCE deflator)



On this side of the pond, the Fed’s determination is exerting growing pressure – in the shape of exchange rates – on an already calamitous inflation-growth mix. The prospects of a recession as a result of the Russian gas crisis have long held back the ECB and the BOE, but the situation is no longer tenable. A combination of stagflation and war are sending most European countries down the path of expansionary fiscal policy and restrictive monetary policy, although there is still quite some scope for development in this respect, with continued very negative real short-term rates in the euro area (cf. chart 3) and the UK. Despite the sharp contrast in the economic situation between Europe and the US, European central banks are staging a radical shift in their stance, just like the Riksbank – Sweden’s central bank – when it recently hiked rates by 100bps. This pressure is most definitely further fueled by recent political events in Italy and the UK, with the ensuing risk of fiscal slippage. The Bank of England in particular is experiencing this severe pressure on central banks’ credibility, after Prime Minister Liz Truss announced tax cuts.



European rates remain far short of projected inflation in 2023

Bloomberg consensus for euro area inflation in 2023 / ESTR expected by the markets in May 2023


In light of revised positions from central banks – and particularly the Fed – we have considerably cut back our equity exposure rate in our international flexible funds since September 21. However, we remain watchful and poised ready to react, as the financial markets have already priced in a great deal of bad news ahead of a period that should nevertheless be characterized by a process of gradual disinflation. Looking to the bond markets, we maintain our short position on the short end of the German yield curve. For the moment, most of our portfolios are invested in the euro area money market, which should benefit from the ECB’s rate hikes.



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