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Interest Rate Risk Insights

By Richard "Crit" Thomas, CFA, CAIA
Income Investing
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Interest Rate Risk

Conclusion: Our analysis suggests structural supply and demand forces (of more savings than investment) 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, we see upside risk to interest rates due to the massive wave of global monetary stimulus put in place during 2019 coupled with the U.S. Federal Reserve Board (Fed) signaling that they may let inflation run above its 2% target. Longer term, we expect the 10-year Treasury yield to remain in a range of 1.5% to 3.0% (assuming no recession).

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 policy stance is neutral, but we have decided to move our signal toward “Loose” in recognition of two factors. First is due to the wave of monetary stimulus around the world with 45 central banks cutting rates; the most seen since the last recession. Second is the changed tone by the Fed with regard to inflation targeting. This may suggest an extended period of looser monetary policy.

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. A slowing in global economic growth and attractive yields relative to other developed countries has increased the global supply of money looking for safer assets such as Treasury bonds. This global shift toward safety could quickly reverse and put upward pressure on Treasury bond yields.

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 (or investment). 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, and it makes the economy more interest rate sensitive.

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.

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 had moved down earlier this year due to mortgage-backed securities (MBS). As interest rates fall, mortgage holders are expected to refinance in greater numbers. 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

Glossary of Investment Terms and Index Definitions


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

Richard "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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