Interest Rate Risk
Conclusion: We believe that non-market factors may be influencing supply and demand. A large portion of fiscal stimulus has added to savings, while the nature of the Fed’s QE program locks up a large portion of the Treasury market. We believe that fiscal and monetary tailwinds are likely to subside with time, alleviating some of these pressures and potentially allowing yields to move higher. Yet, longer term Treasury yields may not be that far from fair value based on underlying fundamentals. Our Treasury yield model indicates the 10-year Treasury should currently be yielding approximately 1.55%. Over time, we believe tighter labor conditions and a modest rise in short-term rates should allow the yield to move up further toward 1.7%.
- In its effort to accomplish its dual goals of maximum employment and stable inflation, the U.S. Federal Reserve Board (Fed) tends to adjust its policy in a counter cyclical fashion. Efforts to stimulate the economy through monetary policy generally led to higher long-term interest rates and vice versa over time.
- In response to the economic shutdown, the Fed has been swift and generous. In fact, history does not provide any instance of the Fed being this aggressive. In addition to lower short-term interest rates, the Fed also bought, and continues to buy, Treasury bonds through its QE program. This has added to supply and put additional downward pressure on interest rates. Yet, with the economy rebounding and the unemployment rate falling, we expect the Fed to begin shifting to a less accommodative stance. We believe the Fed will start with tapering its QE program sometime later this year, taking some of this downward pressure off of longer term interest 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 below, though not all savings goes into bonds nor does all investment require borrowing.
Sources: Bloomberg, U.S. Census Bureau, Bureau of Economic Analysts
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 towards investment, but towards replacing lost income and the building up of cash. As such, this borrowing will have little stimulative impact for the economy, though certainly it was needed to prevent a more meaningful economic shock.
- We look at capital spending intentions as a more direct measure of investment by corporate America. As can be seen, there has been a strong rebound, though smaller businesses are less enthusiastic given rising input costs and tight labor conditions.
- Growth in revolving credit and auto loans suggests the U.S. consumer has not yet shown signs of a renewed appetite for taking on new debt. Mortgage applications have begun to roll over due to fewer refinancings and low supply of homes on the market, though remain at the highs of the last cycle.
Sources: Bloomberg, U.S. Census Bureau, National Federation of Independent Businesses, Mortgage Bankers Assoc.
Simple Bloomberg U.S. Aggregate Index Model Suggests Low Returns
Given that the Bloomberg U.S. Aggregate Bond Index (the Agg) 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 Agg has modestly begun to rise with the economic recovery, though we are not yet near levels that would be considered attractive.
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 is at 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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