One week / one topic: Great expectations

What happened?

Hardly a week goes by without something happening somewhere. Usually, you can convince yourself that it is relevant for financial markets.

And yet, from time to time you also need to step away from the constant distraction and try to look at the landscape from a distance.

In the hope to gain some new perspective, this week I built a tool which I am calling the Great Expectations chart.

It aims to measure the market‑implied cyclical deviation of policy from its perceived long‑run anchor, and it is calculated as follows:

• The implied terminal policy rate is based on SOFR futures 3 years out

• The far-forward neutral rate is based on a 1 month / 10-year OIS (overnight indexed swap)

• The difference between the two is defined as the expected policy stance vs neutral

(For any non-constructive, nitpicking criticism please refer to the ‘Man in the arena’ speech)

Put simply:

• Positive number -> policy expected to overshoot neutral for a time

• Negative number -> policy expected to run below neutral for a time

In its uncaptioned form, this is what the chart looks like for US Federal Reserve rates:

This matters because – like it or not – cross-asset returns are very sensitive to whether policy is leaning against or with the cycle.

Furthermore, what I think matters most are turning points in this measure, as this is when investors must abandon a previously held narrative and meaningfully adjust expectations.

Usually, such moments bring about large moves in asset prices.

With all that in mind – plus the invaluable benefit of hindsight – we can then look at the chart and identify four clear turning points:

• December 2020: Hawkish turn as vaccine breakthroughs and large fiscal stimulus sharply improved the medium‑term growth and inflation outlook, prompting markets to pull forward tapering and liftoff expectations despite dovish guidance.

• October 2022: Dovish turn as acute financial‑stability stresses and already‑tight financial conditions signalled limits to further aggressive tightening, leading markets to price a lower terminal rate and an earlier end to hikes.

• January 2025: Dovish turn as cumulative evidence of labour‑market cooling and growth sensitivity to high rates shifted the reaction function toward insurance cuts, accelerating expectations for the pace and depth of easing.

• September 2025: Hawkish turn as sticky inflation, visible tariffs pass‑through, resilient growth and cautious Fed communication undermined assumptions of aggressive easing, driving a repricing toward fewer cuts and a higher terminal rate.

According to this map then, we are still in the territory of loose policy expectations vs neutral – but potentially on our way towards a more neutral stance.

What conclusions can we draw then for portfolio positioning?

Our observations

• Fundamentals: While of course there are many more determinants to financial asset returns, it’s hard to think of something more consequential than central bank policy.

  From time to time there are things that matter more of course, but – as long as we have the current system of inflation targeting in the context of high debt loads – this variable is likely to remain dominant.

• Price action: Turning points matter, of course – but unfortunately, I can’t think of an obvious way to take advantage of this.

  Not only these moments are usually only clear in hindsight, but you also need to correctly identify which asset classes are more likely to react to these sea changes. Nobody said this was going to be easy…

• Investor beliefs: Investors have been conditioned to believe in the near omnipotence of central banks.

  Through a series bigger and faster crisis responses – think Covid > Great Financial Crisis > dot com bust – this belief has been rewarded, and a whole generation joined the ‘buy-the-dip’ credo.

So what?

As per the ‘Great Expectations’ chart above, it’s noticeable that policy expectations have very rarely been hawkish.

After several years of disinflationary concerns – do you remember the ‘secular stagnation’ phase? – we’ve been through an ‘inflation emergency’ in 2022.

Based on the delayed monetary policy response then (permanent vs transitory), plus an increasingly loose fiscal stance, markets are now more convinced that inflation fighting has permanently moved down on the priority list of US policymakers.

If that would naturally decrease the attractiveness of US Treasury positions – and developed markets government bonds in general, given the inevitable anchoring effect of US rates – we are then facing important questions.

Do you want to run lower duration in portfolios? If not, where else can you source it given the decreased attractiveness of developed markets government bonds?

Lo and behold, realized inflation data can point us in the right direction.

Taking the average CPI inflation for Brazil, Chile, Colombia, Mexico and Peru (orange line) we can observe the convergence towards US inflation levels over time.

Furthermore, there are at least three further reasons to lean towards having more portfolio-level duration in these countries’ local currency bonds:

• Local central banks are currently much more focused on inflation fighting than the Fed

• Local central banks have hiked rates earlier in response to the Covid-induced inflation spike

• Overall debt levels are lower in these countries and not growing as fast vs the US (or many other developed markets)

Granted, there are mitigating factors in the form of liquidity considerations and questions about ‘how would these bonds behave in a true, global risk-off move?’.

That said, we remain inclined to (selectively) increase portfolio-level duration contribution from emerging country local currency bonds by moving a bit further down on yield curves, which are also – by and large – now currently upward-sloping.

Mood music: Tracy Chapman – Talkin’ Bout a Revolution

By popular demand, here is the One week / One topic playlist