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Portfolio sensitivity to interest-rate ups and downs: An analysis of the key drivers

For investors thinking about changes in interest rates and the impact on their portfolios, it’s important to consider what’s driving the change. Investment Strategy Analyst Daniel Cook explains how different asset classes react to changes in real yields and inflation expectations, to help investors manage risk and better understand portfolio bets.

The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

KEY POINTS

  • Real yields and inflation expectations, the two components of nominal rates, can move in different directions and independently impact assets.
  • Within commodities, for example, crude oil and industrial metals have responded positively to rising inflation expectations but had no meaningful relationship to real yields, while gold has had the most positive response to falling real yields of any asset class tested.
  • Asset sensitivity to interest-rate changes can vary over time, often depending on the market regime.

Interest rates have fluctuated markedly this year and the effects have rippled through broader markets. Asset allocators often ask us how interest rates will change going forward and how their portfolios are likely to react. The answer is nuanced and depends on what’s driving the change: real yields or inflation expectations. These two components of nominal rates may move in different directions (Figure 1) and each can independently impact assets. Understanding these relationships can help investors manage risk and better understand the bets they’re making in portfolios.

FIGURE 1

The changing components of nominal interest rates

Isolating the impact of real yields and inflation expectations

We used multivariate regression in which asset class performance is explained by changes in real yields and inflation expectations, as measured by breakeven inflation rates from Treasury inflation-protected securities (TIPS). The betas in Figure 2 are a measure of that sensitivity; they show the percent change the asset class would experience given a one percentage point move in one of the two components, holding the other constant. Assets on the top half of the chart have positive betas to real yields, and those on the right side have positive betas to inflation expectations. To put it in simple terms, assets on the top half of the chart have responded positively to rising real yields and those on the bottom half have responded positively to falling real yields. Assets on the right side of the chart have responded positively to rising inflation expectations and those on the left side have responded positively to falling inflation expectations.

It’s also important to know the statistical significance of the betas. Those that are significant at the 10% level (meaning, simply put, that there is a less than 10% probability the actual beta is zero — i.e., that there is no relationship) are indicated by the symbols shown in the chart key (see appendix for complete results).

FIGURE 2

Sensitivities to real yields and inflation expectations vary by asset class

As the chart shows, asset class reactions to changes in real yields and inflation expectations have varied widely. Equities have generally responded positively to rising real yields and rising inflation expectations. Importantly, equities have been about twice as sensitive to changes in inflation expectations as they have to changes in real yields. The relationship to inflation expectations is statistically significant for all of the regional equity indices tested, while the relationship to real yields is statistically significant for only half of them.

Commodities have responded positively to rising inflation expectations. In fact, the sensitivity of crude oil to inflation expectations is more than twice that of equities. Neither crude oil nor industrial metals has had any relationship with real yields — both betas are close to zero with virtually no statistical significance. Gold has had the most negative sensitivity to real yields of any asset class tested (meaning it has the most positive response to falling real yields) and the relationship is statistically significant. Thus, if an allocator is concerned about rising inflation, crude oil and industrial metals may be good hedges, while gold may be better suited as…

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