Monthly Asset Allocation Highlights – Ebbs and Flows


This is an excerpt from the April Asset Allocation Monthly

The ebb and flow of real interest rates in the United States, inflation expectations and the future level of policy rates remain the main drivers of asset returns globally.

Yields on local currency emerging market debt, for example, largely mirrored those in the US, as did the relative performance of value stocks versus growth stocks.

Eurozone government bonds, however, retraced some of February’s selloff thanks to a more assertive European Central Bank.

Changing dynamics behind rising interest rates

The rise in US interest rates continued in March, although at a slower pace. The mix was also different: Yields on ten-year US Treasuries rose another 34 basis points (bps) after a similar jump in February. Market expectations for the future level of the federal funds rate also rose.

The most significant change in market dynamics has been a shift in the balance between contributions from real yields and those from inflation expectations. In February, most of the rise in five- and ten-year nominal yields was due to higher real yields, but in March it was inflation expectations that rose the most (see chart 1).

Market expects no change in deflationary trend

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

On the one hand, the Fed has sent the message that it is not concerned about rising market yields as this reflects welcome prospects for stronger growth and higher inflation. Five-year/five-year inflation expectations rose to 2.4%. Although this is the highest level since 2018, it is still below pre-Global Financial Crisis levels by closer to 3%. It was the last time the Fed hit its 2% inflation target, as measured by core PCE (personal consumption expenditure).

The market is anticipating much higher inflation over the next year as the US economy emerges from lockdown, the latest fiscal stimulus measures boost growth and supply chains remain disrupted. This suggests that despite inflation’s short-term overshoot, the market does not expect a change in the pre-existing long-term disinflationary dynamic.

Will the Fed act sooner on rates?

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

The latest “dot plot” showed that only seven of the 18 members of the Federal Open Market Committee (FOMC) expected an increase in key rates by 2023. The Fed stressed that rates would only rise after the end of quantitative easing (QE) purchases. It is unlikely before 2023.

Nonetheless, the market has raised its expectation for the fed funds rate and is currently pricing in a rate at least 50 basis points higher within two years. This expected rise in key rates could be another reason why the medium-term inflation forecast has not yet increased: despite the Fed’s insistence on tolerating above-target inflation, the market seems to doubt that she is so forgiving. Higher policy rates would slow growth and limit inflation.

Cautious about interest rates

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

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

Similarly, if the Fed can convince the market that it will be patient before reducing QE or raising rates, this would lower expectations for policy rates as well as real yields. Falling nominal yields could be more than offset by rising inflation expectations.

We remain cautious on the interest rate outlook and favor assets that can benefit from reflation.

Read the full Monthly Asset Allocation Analysis here

All opinions expressed herein 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 have different views and make different investment decisions for different clients. This document does not constitute investment advice.

The value of investments and the income from them can go down as well as up and investors may not get back their initial investment. Past performance does not guarantee future returns.

Investing in emerging markets, or in specialized or restricted sectors is likely to be subject to above average volatility due to a high degree of concentration, greater uncertainty as 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 developed international markets. For this reason, portfolio transaction, liquidation and custody services on behalf of funds investing in emerging markets may involve greater risk.


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