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Capital market insights Conversation guide Nationwide Market InsightsSM The bright side of higher rates Higher interest rates may seem like bad news for consumers and businesses, but recent rate increases — especially from historically low levels around the world — indicate improving prospects for global growth and the potential for higher U.S. government spending under a Trump administration. Deflation fears are quickly receding to the background % The long-term trend in interest rates is supported by economic fundamentals A steeper yield curve lowers the likelihood of a near-term recession Barron’s Best Fund Families, February 2016 edition % Deflation fears are quickly receding to the background • Rising interest rates in the U.S. and other developed economies reflect recent reports of improving economic health—accelerating growth and rising consumer prices } Not only have yields on 10-year U.S. Treasury notes increased (up 50 basis points from July lows), but so have sovereign bond yields in the U.K., Germany and Canada } Many of the concerns that had stoked global deflation fears (e.g., Brexit, slower growth in the U.S., market turmoil in China) have shown to be less worrisome than previously believed •T he headline U.S. annual inflation rate for September was reported at 1.5%, the highest level in nearly two years, while the annualized core inflation rate (less food and energy costs) remained steady at 2.2% •M arket-based indicators of inflation expectations are as high as they have been in a year and appear poised to rise further (see chart below) Breakeven U.S. Inflation Expectation based on 10-year U.S. Treasury market data Jan. 1, 2015 through Nov. 7, 2016 2.00% 2.00% 11/7/16 1.72% 1.75% 1.75% 1.50% 1.50% 1.25% 1.25% 2015 2015 Q2 Q2 Q3 Q3 Q4 Q4 2016 2016 Q2 Q2 Q3 Q3 Q4 Q4 Source: Strategas Research Partners Capital market insights | 2 % The long-term trend in interest rates is supported by economic fundamentals • A supply/demand imbalance in the U.S. government bond market supports a longer-term trend of rising interest rates } Domestic demand for U.S. Treasuries has leveled off with the end of the Federal Reserve’s bond-buying “quantitative easing” program (see chart at left below) } Foreign demand for U.S. Treasuries has dropped dramatically (see chart at right below) as U.S. dollar weakness relative to the Euro and Yen has made U.S. assets less attractive to international investors } On the flip side, U.S. Treasury bond supply is expected to increase with Trump’s economic stimulus proposals and an expanding federal budget deficit •W hile these economic conditions should continue to drive the long-term trend of higher interest rates, investors can expect periods of short-term bond market volatility U.S. Treasuries held by the Federal Reserve U.S. Treasuries held by foreign central banks March 2011 to March 2016 January 2012 to November 2016 $3.0 120% 120% Total US Treasury holdings $T (left axis) 15% $3.2 Total US Treasury holdings $T (left axis) Year-over-year % change (right axis) Year-over-year % change (right axis) $3.0 10% $2.8 5% $2.6 0% $2.4 -5% 80% 80% $2.0 40% 40% $1.0 0% 0% 2012 2013 2014 Source: Federal Reserve Bank of St. Louis 2015 2016 2012 2013 2014 2015 2016 Source: Federal Reserve Bank of St. Louis Capital market insights | 3 OLD 42 - NEW 41 • A steepening yield curve — when longer-term interest rates rise more than short-term rates—is normal, healthy and expected under good economic conditions A steeper yield curve lowers the likelihood of a near-term recession • Every economic recession that has occurred over the last 50 years has always been preceded by an inversion of the yield curve — when long-term interest rates fall below short-term rates (see chart below) economy • U.S. With longer-term interest rates moving higher as of late, the likelihood of the U.S. economy falling into recession appears more remote The yield curve is pointing to continued expansion Spread between the 10-year U.S. Treasury yield and the federal funds target rate Spread between 10-year U.S. Treasury yield and the federal funds target rate Percent The indicator that best encapsulates the stance of monetary policy relative to the state of the economy is the yield curve, the spread between longand short-term interest rates. 6% 4% Normal Yield Curve In fact, the curve has been the single best leading indicator of economic performance, as it has inverted in front of every modern recession and has steepened before every recovery. 2% 0% -2% The curve has been in a flattening trend for years now, but it Yield is still steep by Inverted Curve historical standards. It will take substantially more Fed tightening from here for monetary policy to be truly restrictive and for this recovery to be in jeopardy. -4% -6% -8% 1971 1976 1981 1896 1991 1996 2001 2006 2011 2016 Note: Shaded areas depict recessionary periods Source: Bloomberg Note: Shaded areas depict recessionary periods Source: Bloomberg 4th Quarter 2016, Data as of September 30, 2016 Nationwide Capital market insights |4 Retirement Institute 41 Key takeaways Interest rates on U.S. government bonds have increased with market expectations of a Federal Reserve rate hike in December. Rising rates on longer-term bonds reflect optimism about the U.S. economy — growth is accelerating and consumer prices show signs of increasing following an extended period of sluggish inflation and deflationary concerns. Rising rates would be welcome news to fixed income investors, who have been starved for yield for several years in the recent low interest rate environment. • Keep in mind that rising interest rates are not necessarily bad news for bond investors — although bond values decline when rates rise, income from bond yields has historically contributed more to bonds’ total returns • Look for opportunities to manage the risk of rising interest rates by diversifying fixed income holdings into areas that may not be as sensitive to interest rate increases 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. Nationwide Funds distributed by Nationwide Fund Distributors LLC (NFD), Member FINRA, Columbus, OH. 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. © 2016 Nationwide NFM-15938AO (11/16)