Capital market insights Conversation guide Nationwide Market Insights SM Keep cool as interest rates rise. Interest rates rose higher in the wake of President Trump s election last November. Expectations for more Fed rate hikes later this year (following the quarter-point increase in March) are also pushing rates up, especially on the short end of the yield curve. Investors who are concerned about what rising rates may mean for their bond holdings should take a longer-term view, as bond market performance has been favorable in previous cycles of rising interest rates. Understanding the yield curve can help set expectations for future economic conditions A more cautious Fed has emerged in this rate-hike cycle $ Fixed income returns have remained positive during past rate hike cycles
Understanding the yield curve can help set expectations for future economic conditions A steepening yield curve, where longer-term interest rates rise faster than shorter-term rates, typically indicates an economy that is relatively strong and a potential trend of higher interest rates going forward. The yield curve steepened in the weeks immediately following the U.S. presidential election, reflecting investors brighter outlook for Trump s economic policies. The yield curve flattens when short-term interest rates rise faster than long-term rates, typically indicating growing concern about future economic growth. The recent flattening of the yield curve came as shorter-term rates rose in anticipation of the Federal Reserve s quarter-point hike at its March meeting and longer-term rates softened on greater demand for U.S. Treasuries from investors fleeing higher risk markets (e.g. Eurozone). An inverted yield curve, when short-term rates rise above long-term rates, indicates higher aversion to risk among investors and has historically preceded an economic recession. The current shape of the yield curve is far from an inversion, suggesting continued economic growth with little chance of a near-term recession. Chart 1: Spread (difference in yield) between 10-year and 2-year U.S. Treasuries March 1987-March 2017 300 10-yr/2-yr US Treasury spread Recession 200 100 Yield curve steepens Trump wins Mar-1987 Mar-1992 Mar-1997 Mar-2002 Mar-2007 Mar-2012 Mar-2017-100 Source for chart data: FactSet Research Systems Inverted yield curve (Spread below 0) Capital market insights 2
A more cautious Fed has emerged in this rate-hike cycle In the past, the Federal Reserve has adopted a more methodical and measured approach when increasing interest rates. For example, the Fed hiked rates at 18 consecutive Federal Open Market Committee meetings in the rising rate cycle of 2004-2006 (see chart below.) The Fed followed a similar stair-step path when it hiked rates in 1993-94 and 1999-2000. The current rate hike cycle, which started in December 2015, shows the Federal Reserve taking a more staggered climb toward tighter monetary policy. The Fed s more cautious approach is a result of the mediocre economic expansion in the wake of the financial crisis and Great Recession and wariness about quashing growth just as it is beginning to pick up. Chart 2: Federal funds target rate, 1990 - March 2017 10% 8% 6% More methodical rate hikes in 1993-94 and 1999-2000 4% 2% More staggered rate hikes since Dec. 2015 1990 1995 2000 2005 2010 2015 Source for chart data: FactSet Research Systems Capital market insights 3
$ Fixed income returns have remained positive during past rate hike cycles Spreads in the U.S. government and corporate bond markets have shrunk, but they remain above the lowest lows seen over the last 10-15 years. A spread is the difference in interest rates between two types of bonds, such as long- and short-term interest rates for government bonds or investment-grade (higher quality) and high-yield (lower quality) bonds in the corporate market. The current positive outlook for company earnings adds some resilience to the investment-grade and highyield bond markets. Both the shape of yield curve (flattening) and corporate bonds spreads (tightening) are consistent with a late expansion phase of the business cycle. Fixed income indexes have historically had positive returns in cycles of rising rates (see charts below), so investors should not entirely abandon fixed income investments due to fear of falling values. Chart 3: Fixed income market returns during past rising interest rate cycles Annualized returns in the Bloomberg Barclays U.S. Aggregate Bond Index during Federal Reserve tightening cycles Annualized fixed income returns during the 2004 06 tightening cycle percent Source: Bloomberg Source: Barclays Capital market insights 4
Key takeaways The fixed income markets are muddling through a murky period, following a swift rise of 77 basis points in the 10-year US Treasury rate between President Trump s election and mid-march. Bond investors remain uncertain about Trump s agenda and related GOP proposals, and with more Fed rate hikes expected later in 2017, they will likely have to contend with higher rates and an inverse effect on bond values. Positive returns in fixed income markets during previous rising rate periods, however, may offer some context to help investors set expectations for their own portfolios. Remember the two components of a bond investment s total return price return and income return; the higher income related to rising rates has historically helped bond indexes achieve positive total returns in past rising rate periods. Maintain your bond allocation in alignment with your overall investment goals. Keep your cool as interest rates may become more volatile in response to changing political headwinds. For more help or information, contact your financial advisor. www.nationwide.com/mutualfunds This material is not a recommendation to buy, sell, hold, or rollover any asset, adopt an investment strategy, retain a specific investment manager or use a particular account type. It does not take into account the specific investment objectives, tax and financial condition or particular needs of any specific person. Investors should work with their financial professional to discuss their specific situation. Except where otherwise indicated, the views and opinions expressed are those of Nationwide as of the date noted, are subject to change at any time, and may not come to pass. Bloomberg Barclays US Aggregate Bond Index: An unmanaged, market value-weighted index of U.S. dollar-denominated, investment-grade, fixed-rate, taxable debt issues, which includes Treasuries, government-related and corporate securities, mortgage- backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities and commercial mortgage-backed securities (agency and non-agency). Nationwide Funds are distributed by Nationwide Fund Distributors LLC (NFD), member FINRA, Columbus, Ohio. Nationwide Investment Services Corporation, member FINRA. Nationwide, the Nationwide N and Eagle and Nationwide is on your side are service marks of Nationwide Mutual Insurance Company. 2017 Nationwide NFM-16289AO (03/17)