Interest Rate Risk
Conclusion: Much higher than expected inflation has put the Fed on a more aggressive path. 10-year Treasury yields have surged above 3%. We increased duration when rates moved higher and will do so again should they move up even further. The Fed’s resolve to tame inflation is likely to slow economic growth and will eventually create a ceiling for longer-term rates.
In its effort to accomplish its dual goals of maximum employment and stable inflation, the Fed tends to adjust its policy in a counter cyclical fashion. Efforts to stimulate (restrict) the economy through monetary policy generally led to higher (lower) long-term interest rates and vice versa over time. Yet, this cycle is different as the Fed is acting pro-cyclically as it did not anticipate the degree of inflation.
- Measures of inflation have pushed well above expectations and have broadened into more sticky sectors. This has put the Fed well behind the curve. While current policy is still accommodative, given negative real rates, the Fed plans to get to a tighter position sooner than expected. 10-year yields may have broken out of a four-decade pattern of making lower lows in each cycle, though should the Fed succeed in taming inflation (our base case), we do not anticipate moving into a secular period of rising rates.
Supply refers to lending and is represented by savings and investments. Excess supply puts downward pressure on interest rates.
- The vast majority of U.S. savings are held by consumers, including contributions to pension plans.
- Retirement savings have swelled as the Baby Boom generation nears retirement age. Typically, there has been a tendency to accelerate the pace of savings and begin to make asset allocation changes toward less risky, more income-generative assets (e.g., bonds), as one gets closer to retiring and into retirement.
- The supply/demand approach to interest rates can also be thought of as savings versus investment. Savings represents money looking to lend, while investment money looking to borrow, and rates adjust to accommodate changes in these two factors. The right chart below broadly depicts this relationship. Fiscal stimulus measures to offset the pandemic have significantly added to savings. While the rate of saving is coming down, it remains well above that of investment.
- Demand refers to borrowing (or investment). Excess demand puts upward pressure on interest rates, while insufficient demand puts downward pressure on interest rates. In the past, we have used measures of the change in debt outstanding to indicate whether demand is abundant or scarce. There has been a dramatic increase in borrowing by the government and business sector, but we believe showing these figures would be distortionary. The vast majority of debt issuance has gone not toward investment, but toward replacing lost income and the building up of cash.
- One of the main channels of monetary policy is to encourage or discourage investment. Certainly higher mortgage rates are having an impact. So far, business investment has held up, though weaker economic conditions are likely to cause businesses to slow spending.
Simple Bloomberg U.S. Aggregate Bond Index Model Suggests Low Returns
Given that the Bloomberg U.S. Aggregate Bond Index typically had a duration of around five years, its current yield has historically tended to be a reasonable estimate for the total return of the index over the next five years. Touchstone uses this Model in developing its asset class return outlook for core fixed income. The yield on the Bloomberg U.S. Aggregate Bond Index has risen to a level that is more attractive. The current yield is near the highest seen in over 10 years.
Bloomberg U.S. Aggregate Bond Index Duration Extended
Duration is a measure of a bond’s price sensitivity to changes in interest rates. As duration rises, bonds become more sensitive to changes in interest rates. The duration risk for the Bloomberg U.S. Aggregate Bond Index remains near its all-time high. Lower interest rates and longer maturity Treasury and corporate issuance extended the duration over the course of the last decade.
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