Interest Rate Risk
Conclusion: Our analysis suggests structural supply and demand forces (of more savings than investment) are behind the low rate environment. In the near-term, these secular forces have been amplified by slowing economic growth from the coronavirus outbreak. As the economy reopens we expect that cyclical forces will put upward pressure on longer-term interest rates. Looking out further into the recovery the picture becomes less clear. In the past we have noted secular forces such as demographics that have put downward pressure on interest rates. This next cycle could be different given significant fiscal and monetary stimulus (with potentially more on the way) and a changed tone at the Federal Reserve Board (the Fed) toward inflation. We will be monitoring this closely, though currently still lean toward the secular stagnation camp, expecting sub-par economic growth.
- In its effort to accomplish its dual goals of maximum employment and stable inflation, the U.S. Federal Reserve Board tends to adjust its policy in a counter cyclical fashion. Efforts to stimulate the economy through monetary policy generally lead to higher long-term interest rates and vice versa over time. Should the Fed adopt yield curve control it would preclude a rise in long-term rates in the near-term.
- 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. At this point little of the Fed’s actions have stimulated the economy due to the shutdown, but it has had a very positive impact on risk assets. There is early evidence of low interest rates stimulating demand for mortgages and auto loans. That said, for those worried about a return to inflation, we would need to see the velocity of money begin to accelerate.*
*There is a widely held misperception that the QE program creates money, but money creation occurs through bank lending. QE is meant to encourage borrowing (not lending) through lower interest rates. This is why we believe the Fed should not adopt yield curve control, where they would set long rates as well as short rates. A steeper yield curve is needed to encourage bank lending and economic growth.
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.
- There are also cyclical factors that influence supply. As can be seen in the right chart below, the savings rate has increased dramatically. Most of this is due to the economic shutdown and will likely reverse, but we anticipate a higher rate of savings to continue into the next cycle providing additional downward cyclical pressure on interest rates.
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, this growth has turned negative.
- We have seen an indication amongst U.S. consumers to take on debt for the purchase of new homes and autos, though it is too early to gauge the true magnitude or how long it will be sustained.
Sources: Bloomberg, U.S. Census Bureau, National Federation of Independent Businesses, Mortgage Bankers Assoc.
Simple Bloomberg Barclays U.S. Aggregate Index Model Suggests Low Returns
Given that the Bloomberg Barclays U.S. Aggregate Bond Index (the “Agg”) typically has 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. Actions by the Fed have brought interest rates down. The May closing yield on the Agg is near the all-time low. We believe these low rates are likely to push investors out the risk spectrum to source additional yield.
Source: Bloomberg Barclays
Bloomberg Barclays 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 Barclays U.S. Aggregate Bond Index is near its all time high. Lower interest rates and longer maturity Treasury issuance extended the duration back to near all-time highs.
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