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Interest Rate Risk Insights: 3Q | 2019

By R. Crit Thomas, CFA, CAIA
Income Investing
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Interest Rate Risk

Conclusion: Our analysis suggests structural supply and demand forces are behind the current low rate environment. We do not anticipate these structural issues to completely resolve themselves in the next three to five years. In the near term, it appears that the U.S. Federal Reserve Board’s (Fed) next move may be to lower rates in response to slowing economic conditions both here and abroad, and less inflationary pressure. Our signals remain inconclusive on the direction of rates, though we expect the 10-year to remain in a range of 1.5% to 3.0% for the foreseeable future.

Our views on Interest Rates are based on measures of monetary policy, supply and demand, as well as historical returns and duration.

Monetary Policy

  • 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.
  • The current economic cycle was somewhat unique in that the Fed maintained a very accommodative stance, yet longer term interest rates remained range bound. We believe this is evidence that monetary policy has been less effective in this recovery, due mainly to secular supply and demand forces.
  • Our Fed model suggests that the Fed has moved toward a more neutral policy stance, yet it is looking more likely the Fed’s next move will be to lower rates. If so, the path to a restrictive posture may not occur for some time (years?). The yield on the 10-year Treasury bond has moved significantly lower, though it remains well within the 1.5% to 3.0% range it has been in for the last seven years. We believe a more dovish Fed will keep this trading range intact.

Touchstone Fed Model*Model based on inflation-adjusted Federal Funds and term structure of interest rates.
Sources: Bloomberg, Touchstone Investments

Increased Supply

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. Current late cycle conditions, expected slowing in economic growth and inflation due to waning monetary and fiscal stimulus, and uncertainties surrounding tariffs have increased the supply of money looking for safer assets such as Treasury bonds. That said, this shift towards safety could quickly reverse.

Share of U.S. Population
Total Retirement Assets*Includes: IRAs, DC plans, DB plans and Annuities
Sources: Bloomberg, U.S. Census Bureau, Investment Company Institute

Demand

Demand refers to borrowing. Excess demand puts upward pressure on interest rates, while insufficient demand puts downward pressure on interest rates. Total debt growth began to outpace gross domestic product (GDP) growth starting in late 2015. Both Business and Federal borrowing have been the drivers of this growth, while Consumer borrowing continues to shrink as a percent of GDP.

  • Consumer demand (household debt growth) has remained weak throughout this economic cycle due mainly to tighter mortgage lending standards. Mortgages represent two-thirds of household debt outstanding.
  • Business (non-financial) demand has been the fastest growing sector. This has been primarily a supply-driven market where investors seeking higher income generation have encouraged more borrowing from the corporate sector.
  • Federal borrowing has been strong throughout most of this economic cycle. Typically federal government debt begins to shrink as a percent of GDP later in an economic cycle as tax revenues grow, alleviating budgetary pressures. This has not been a typical economic cycle. Looking forward, Federal debt is forecast to grow following passage of the tax bill and two-year budget deal. While not a near-term market issue, this debt burden will eventually reduce U.S. economic growth potential, which makes the economy more interest rate sensitive, and will be an area of concern during the next recession.

Debt Outstanding Nominal GDP Sources: Bloomberg, U.S. Treasury, Bureau of Economic Analysis Institute

Simple Bloomberg Barclays U.S. Aggregate Index Model Suggests Low Returns

Given that the Bloomberg Barclays U.S. Aggregate Index 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. The rate rising cycle has been put on hold, and we may see the Fed lower rates. Unfortunately, a rally in Treasuries has brought yields down, meaning expected returns for this index have become more meager.

Bloomberg Barclays U.S. Aggregate Index: Initial Yield-to-Worst and Subsequent 5-Year Total Return

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. Duration has moved down this year due to mortgage-backed securities (MBS). As rates fall mortgage holders are expected to refinance at a higher rate. This assumption of a higher rate of mortgage refinancing means that investors will see their money returned more quickly, which lowers duration.

Bloomberg Barclays U.S. Aggregate Bond Index Modified Adjusted Duration

Source: Bloomberg


This commentary is for informational purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security. There is no guarantee that the information is complete or timely. Past performance is no guarantee of future results. Investing in an index is not possible. Investing involves risk, including the possible loss of principal and fluctuation of value. Please visit touchstoneinvestments.com for performance information current to the most recent month-end.

Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial advisor or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.

Touchstone Funds are distributed by Touchstone Securities, Inc.*
*A registered broker-dealer and member FINRA/SIPC.

Not FDIC Insured | No Bank Guarantee | May Lose Value

About the Author

crit thomas global market strategist

R. Crit Thomas, CFA, CAIA

Global Market Strategist
Crit is responsible for examining and evaluating economic conditions, generating insights and providing a sharpened perspective on investment strategies for enriched portfolio construction.

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