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Asset allocation monthly highlights – Ebb and flow

Rising US interest rates, with both higher real yields and inflation expectations, are reflecting stronger growth and supply constraints.

This is an extract from the Asset Allocation Monthly for April

The ebb and flow of US real interest rates, inflation expectations and the future level of policy rates remain the key drivers for asset returns globally.

Local currency emerging market debt yields have, for example, largely mirrored those of the US, as has the relative performance of value versus growth stocks.

Eurozone government bonds, however, have retraced part of the February sell-off thanks to a more assertive European Central Bank.

A changing dynamic behind the rise in interest rates

The rise in US interest rates continued in March, albeit more slowly. The mix was also different: Ten-year US Treasury bond yields rose by another 34 basis points (bp) following a similar jump in February. The market’s forecast for the future level of the federal funds rate also rose.

The most significant change in the market dynamic was a shift in the balance between the contributions from real yields and those from inflation expectations. In February, most of the rise in nominal five and 10-year yields was due to higher real yields but in March, it was inflation expectations which rose by the most (see Exhibit 1).

Market foresees no change in deflationary trend

Not all the market moves are necessarily what the US Federal Reserve (the Fed) would like to see.

On the one hand, the Fed has conveyed the message that it is unconcerned about the increase in market yields as this reflects welcome prospects of stronger growth and higher inflation. Five-year/five-year inflation expectations have risen to 2.4%. While this is the highest level since 2018, it is still below pre-Global Financial Crisis levels of nearer 3%. That was the last time the Fed achieved its inflation objective of 2%, as measured by core PCE (personal consumption expenditures).

The market does anticipate much stronger inflation over the next year as the US economy comes out of lockdown, the latest fiscal stimulus boosts growth, and supply chains remain disrupted. This suggests that despite the near-term overshoot in inflation, the market does not foresee a change in the pre-existing long-term disinflationary dynamics.

Will the Fed move earlier on rates?

For all the lack of concern from the Fed about market interest rates, there is, however, concern about the expected level of fed funds in two years’ time and beyond.

The latest “dot plot” showed only seven out of 18 Federal Open Market Committee (FOMC) members expecting an increase in policy rates by 2023. The Fed has emphasised that rates would only rise after quantitative easing (QE) purchases had ended. This is unlikely before 2023.

Nonetheless, the market has increased its forecast for the fed funds rate and is currently pricing in an at least 50bp higher rate within two years. This expected increase in policy rates may be another reason why medium-term forecasts for inflation have not risen further: Despite the Fed’s insistence that it will tolerate above-target inflation, the market appears to doubt it will be so indulgent. Higher policy rates would slow growth and constrain inflation.

Cautious on interest rates

At the same time, there is a risk of much higher consumer price inflation this summer. It could reach 3.5%.

Market observers are well aware of this possibility as much of the gain is simply from base effects, but high readings could still spook the market and lead to a bigger sell-off in government bonds.

Similarly, if the Fed does manage to convince the market that it will be patient before tapering QE or raising rates, this would lower expectations for policy rates as well as real yields. The fall in nominal yields could be more than offset by an increase in inflation expectations.

We remain cautious about the outlook for interest rates and prefer assets which can benefit from the reflation trade.

Read the complete asset allocation monthly analysis here

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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