Economic facts and the fixed income complex… We still expect the main effect of the Fed's adjustments in the fixed income concept on the side of short-term interest rates. When the bilateral effects of current supply bottlenecks and ongoing rapid wage increases are analyzed; We still run the risk of monitoring the inflation effect of this combination faster and longer than expected. Market participants are concerned about stagflation as a combination of high inflation and slow growth within the framework of these risks. We still take into account the inflationary effects of the factors that are the subject of slow growth, and we maintain our expectations for a faster reduction in asset purchases due to an inflation phenomenon that is feared to become structural.
Comparison of fixed returns, spread and inflation expectations (US 5-year bond yield, 5-year inflation break-even and 5-10 year interest spread)... Source: Bloomberg
The effect of the inflation criterion on the movements… The probability of stagflation is actually low under current conditions as the growth seems to continue with a strong outlook. The assumption that Covid cases will not lead to increased restrictions is the basis for not expecting a large-scale recession. Therefore, our characteristic still consists of inflation combined with real GDP growth. Since the Fed changed its inflation target from a linear 2% to an average of 2% last year, the bar is high, but the tendency to avoid the demand-warming effects of the policy's continuation of asset purchases is quite normal. On the other hand, in terms of credit profile, negative real returns as a result of ultra-loose policy and very low nominal returns may be concerned about the effects of the spread of loans that may cause overheating.
Faster tapering… The Fed plans to cut its asset purchases by $15 billion per month in June 2022. Starting next month, the reduction in asset purchases can be continued at a faster pace. The option includes policy flexibility to reduce asset purchases faster if necessary to cool rising inflation. Because, although the economy is approaching more organic growth rates, it continues to grow in this concept and the unemployment rate has approached the desired threshold levels with 4.2%. We think the Fed will not ignore good indicators and a constantly warming inflation. We do not expect periodic negative deviations of data expectations to be the main criterion at this stage.
US core PCE deflator and FOMC inflation target rate… Source: Bloomberg
Conclusion? Specifically, the Fed is likely to increase the tapering rate on Dec. This indicates a QE that may end in April 2022 rather than June 2022, and rate hike expectations to be pushed forward. Economic forecasts will likely evolve to a more hawkish point. In this context, it is likely that the dot graph will be formed in the form of two rate hikes in 2022, followed by the expectation of rate hikes spread over 2023 and 2024. In terms of the move towards the FOMC's long-term estimate of the 2.50% federal funding rate, we believe the change here will rest on higher thresholds. The first thing we will consider is; Rather than realizing the expectations, the faster action of the Fed will increase the short-term interest rates, and in addition, how willing or reference will it be to the rate hike. Taking a cautious stance, the Fed may be observing some downside risks as the variant effect still has potential. Other elements; How temporary or permanent the Fed believes inflation may be (we are still monitoring commodity prices from China) and the labor market will be close to the natural rate of unemployment. The risk weight of these dynamics puts the Fed one step further on tapering.
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