Financial markets have experienced increased volatility driven by uncertainty over trade, higher interest rates, and a drop in oil prices. In a widely expected move, the Federal Open Market Committee earlier this week hiked interest rates by 25 basis points, moving the new target Fed funds range to 2.25-2.50 percent. But where do we go from here, and how might the current environment affect the commercial real estate community?
Short term interest rates are now brushing up against the bottom of the neutral rate—the point at which the Fed believes the interest rate neither accelerates nor decelerates the economy—which is generally believed to be between 2.5 and 3.5 percent. Economic data suggests the US is right around the Fed’s target levels, with an unemployment rate of 3.7 percent (the lowest since October 1969) and an annual inflation rate of 1.8 percent as measured by core Personal Consumption Expenditures. There is only one 2019 rate currently priced into the market, but the Fed projects two hikes, which highlights investors’ need to consider hedging or fixing their rate.
The yield curve remains quite flat, the difference between the 10- and two-year US Treasury yields dipping as low as 11 basis points, potentially indicating less confidence in near-term economic growth prospects and only moderate rate increases. Although the prospect of the 10-year note remaining relatively anchored may sound positive for asset values, investors must watch for yield curve inversion (when a two-year yields more than a 10-year note). Inversion could potentially hurt asset values, as historically a recession has begun within one to two years after an inverted curve. But correlation does not necessarily mean causation, and some economists believe the recent zero-rate environment has changed the historical premium between the two-year and 10-year note.
Markets have grown accustomed to interest rate target movements only taking place at quarter-end meetings, but Fed Chairman Jerome Powell now plans to hold a press conference at the end of every FOMC meeting, allowing for the possibility of movement at any time. This shift allows the Fed to act more nimbly to accommodate changes in the US economy, of which real estate comprises a major part. Real estate construction makes up 7 percent of US gross domestic product, and real estate sales prices play a major role in consumer spending. This is noteworthy because housing sales have been depressed and could give reason for the Fed to pause or temper the pace of its rate hikes.
The trade dispute with China, and its impact on the global economy, remains a major unknown. Those US companies continuing to rely on Chinese imports will either need to eat the higher cost of tariffs themselves, or pass them along to consumers. Although there is much talk of how a trade dispute could slow global growth, these tariffs could potentially (albeit not base case) contribute to higher inflation in the US and could result in the Fed raising rates to temper any potential overheating of the economy. This would apply more pressure on cap rates.
The Fed has been clear that future changes to interest rate targets will be dependent on data such as unemployment and inflation rates. In addition, consumer confidence for all income classes has trended upward for the past five years, wage growth is positive, and we’re experiencing a net labor shortage! Only home sales have shown signs of slowing as a result of higher rates and home prices. Additional rate increases may occur, but the Fed has reason to remain cautious with this market, which is readjusting to a non-zero rate environment and the unwinding of bond purchase stimulus.
In volatile times such as these, those of us in the commercial real estate investment community need to monitor events closely, while also watching the long term. As intriguing as it can be to follow daily ups and downs, keeping an eye on fundamentals and the long game pays off in the end.
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