Dorval Asset Management’s macro/market scenario and exposure rates - October 28, 2022

After significant moves to unwind short positions on both bonds and equities, the markets’ potential now largely hinges on monetary policy and as such, investors will pay close attention to the Fed’s stance and just how determined it is to tackle inflation.

The world bond markets have taken a turn for the better of late, fueled by signs of an economic slowdown and the relative moderation of both words and actions from some central banks, e.g. the Bank of Canada, which only hiked rates by 50bps vs. 75bps expected. The euro area enjoyed a substantial bond rally, with the German 10-year sliding briefly under the 2% mark after the ECB meeting vs. 2.4% at its highest.

Particularly low German bond yields may come as a surprise, and can be partly attributed to the scarcity effect generated by the ECB’s purchases since 2015 (as well as relatively low public debt in Germany). Rises in the ECB’s rates are therefore struggling to trickle through to German bonds, which are in very high demand on the repo market to boot. This situation has recently hit a dramatic point, with German yields 100bps below the swap rate on an equivalent length (cf. chart 1).


  • 5-year swap rate in euro area
  • German 5-year bond yield (zero coupon)
  • Differential

With the ECB now discouraging banks from holding onto surplus liquidity, the money market may well strike a better balance, which will help narrow the rate differential between the two markets over the months ahead. Given resilient German growth in 3Q (GDP up 0.3% vs. -0.2% expected) and ever higher inflation (+11.6% in Germany in October), we think that it is reasonable to expect the differential to narrow as a result of a rise in German bond yields rather than a decrease in swap rates.

Looking further afield, US Treasury yields have also dipped recently, with rumors of a Fed pivot fueling hopes from some observers of a stabilization on the bond markets. No-one expects Jerome Powell to take a complacent approach to inflation of course, but at the risk of stating the obvious, the more Fed rates rise, the closer they get to their high point. The Fed’s latest projections suggest that its rates could stabilize in the region of 4.5% to 5% from the Spring onwards. In an orderly fashion, the financial markets are already pricing in this scenario, which is supporting a market stabilization. The Fed would have to be even more harsh than in September if it is to surprise the market, which some observers doubt given the mid-term elections looming on November 8. Additionally, some believe that the decline in real estate prices and market activity, as well as the deterioration in the business climate (according to the PMI), could lead to a degree of restraint from the Fed (cf. chart 2).


  • NAHB index in residential real estate
  • Composite PMI (survey in industry and services)

Yet inflation figures and new jobless claim stats point to continued resilience for both inflation (cf. chart 3) and the labor market, suggesting that the economy has not yet slowed down sufficiently. Will Jerome Powell dare to ratchet up the pressure again? There is a great deal of uncertainty with an extensive underlying debate on the right direction for monetary policy as we head towards 2023, which will probably be a time of a weaker economy and a decrease in inflation, although perhaps not enough to make the official 2% target credible.


  • Over one month, annualized
  • 6-month moving average

At current projected money-market rates (a bit under 5% in the Spring of 2023) and with the present 10-year rate (which has slid under the three-month rate), there is fairly little chance that US bond yields will decrease on a sustainable basis, even if Jerome Powell does not take a tougher stance than in September. However, on the equity markets, investors may be tempted to rule out a severe recession scenario if the Fed fails to take a more resolute approach, which is exactly what Wall Street seems to have done over the past week or two.

In our international flexible portfolios, we pursue our low equity exposure for now. Our bond duration is now slightly negative (sale of futures on German 5-year). In the absence of a sufficiently significant economic slowdown in the US, we are not adequately convinced of a “peak in long-term yields” scenario to hike our risk exposure rates substantially. We still have a preference for the money market, which benefits from regular rises in short-term rates. We of course stand poised to adjust our positions at any time.

Our exposure rates are as follows:

• Dorval Convictions: our exposure rate is 51%.

Download the weekly letter in PDF version: macro/market scenario and exposure rates 28th october 2022

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