Federal Reserve Building

Interest Rate Hikes Continue

The Federal Reserve hiked interest rates by 25 bps at today’s meeting. This hike will increase the federal funds rate to a target range of 1.50 to 1.75 percent.
Al Brooks, Head of Commercial Real Estate, Commercial Banking
March 21, 2018

Today’s announcement to raise interest rates by 25 bps—to a range of 1.50 to 1.75 percent—came as no surprise to markets. Fed Chairman Jerome Powell was appointed with expectations for continuity in leadership, and he has largely adopted outgoing Chair Janet Yellen’s preference for a program of gradual interest rate hikes and steady balance sheet normalization.

The recently released minutes from the Federal Open Market Committee’s January meeting show a broad agreement among policymakers that the economy is strong and faces balanced risks. The committee’s stance is that gradually raising interest rates will be appropriate as growth continues to accelerate and the economy moves closer to operating at its full potential.

Historic Rate Hike View

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This chart shows the Federal Funds Target Rate, Upper Limit from December 2007 until Mach 2018. The Federal Funds Target Rate (upper limit) was at .25% From December 2017 until December 2015, when it increased to .50%. In December 2016, it increased to .75%; April 2017 they were 1.0%; 1.25% in July 2017; 1.5% in December 2017; 1.75% in March of 2018.
 

Source: The Federal Reserve; Federal Funds Target Rate, Upper Limit

The Fed’s long-term projections show interest rates stabilizing just shy of 3 percent, and today the Fed indicated we are likely to see two additional hikes in 2018—and a potential for three hikes in 2019, instead of the two hikes they previously indicated.

J.P. Morgan Markets Interest Rate Forecast

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This chart shows J.P. Morgan Markets’ interest rate forecast for Q2 2018, Q3 2018, Q4 2018 and Q1 2019; for 3-Month Libor the forecasts are: 2.35%, 2.55%, 2.85% and 3.05%; for the 3-Year Treasury the forecasts are: 2.6%, 2.8%, 3% and 3.15%; for the 5-Year Treasury the forecasts are: 2.75%, 2.9%, 3.0% and 3.2%; for the 7-Year Treasury the forecasts are: 2.85%, 2.95%, 3.05% and 3.2%; for the 10-Year Treasury the forecasts are: 3%, 3.05%, 3.15% and 3.25%; for the 30-Year Treasury the forecasts are: 3.15%, 3.2%, 3.25% and 3.3%.
 

Source: J.P. Morgan Markets, as of March 16, 2018

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Unemployment: Are We There Yet?

The labor market has added an average of 205,000 jobs every month since July 2017, bringing the headline unemployment rate to 4.1 percent, the lowest it has been in recent years. The rate of job creation is outstripping underlying population growth, driving the unemployment rate a full half point below policymakers’ projections for its longer-run equilibrium.

Labor Force Statistics

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This charts shows the change month over month of the unemployment rate compared to a full employment baseline of 5%. The unemployment rate was 4.7% in January of 2007, increased to a high of 9.9% in November of 2009 and decreased to 4.1% in November of 2017.
 

Source: U.S. Department of Labor

The unemployment rate is well below normal, but the Fed’s minutes show uncertainty about the amount of slack remaining in the labor market. The labor force participation rate is still low by historical standards, implying that millions of discouraged workforce dropouts may still return to the job market as conditions improve.

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Continued Economic Growth

Recent tax reform legislation and a growing federal budget are set to provide additional fiscal stimulus this year, further boosting economic growth. Tax cuts are projected to reduce federal revenues by $205 billion in 2018, leaving more money in the hands of private citizens and encouraging new investments from businesses—both positives for the commercial real estate market.

Tax Reform’s Impact on the Economy

This chart shows the reduction of the corporate tax from a cap out at 35% to a single 21% rate.
35%

The Tax Cuts and Jobs Act permanently reduces the corporate tax rate—from a structure that caps out at 35 percent to a single 21 percent rate—giving businesses a clearer picture of the policy outlook. This could lower the effective tax rate from 25 percent to near 21 percent.

This chart shows the combined $69 billion anticipated from repatriated profits and the $205 billion expected lower tax revenues in 2018
$69 billion anticipated from repatriated profits $205 billion expected lower tax revenues in 2018

The tax initiative is expected to lower tax revenues by $205 billion in 2018, not counting the $69 billion anticipated to be raised from repatriated profits. This should put more money in the hands of consumers in the coming year.

Some analysts are worried the Fed will be forced to move up its timeline for interest rate normalization if the economy accelerates further, but fiscal stimulus shouldn’t lead to overheating.

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The Consensus of Rising Yields

Although still historically low, 10-year Treasury yields have risen rapidly in 2018, reflecting a growing consensus that the Fed will deliver on its inflation and interest rate forecasts. For many years, long-term Treasury yields have been depressed by quantitative easing, but as the Fed unwinds its balance sheet and foreign central banks begin to taper their asset-purchasing programs, yields have surged back toward a natural equilibrium.

10-Year Treasury Yields

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This chart shows yields on 10-Year Treasuries; the week of January 1, 2016 yields were at 2.29%. As of Friday, March 2, yields were at 2.86% for 10-Year Treasuries.
 

Source: The Federal Reserve

At 2.86 percent, the current 10-year yield reflects investors’ assumptions that inflation will stabilize around the Fed’s 2 percent target as interest rates continue to gradually rise.

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A Positive Outlook for Commercial Real Estate

Rising rates will push borrowing costs higher, but commercial real estate investors should not be discouraged. Although interest rates are expected to rise and capitalization rates may trend upward—rates are still well below historical norms, and even the most hawkish policymakers are calling for a gradual normalization process.

The commercial real estate sector should continue to see tailwinds from strong job creation and steady economic growth. Investors should prepare for higher interest rates in the coming years—with the understanding that the peak of the business cycle will bring new opportunities for the commercial real estate industry. Demand for living and working space is growing in tandem with the broader economy, and marginally higher borrowing costs should be offset by the positives that accompany a strong business environment.

 

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© 2018 JPMorgan Chase & Co. All rights reserved. Chase is a marketing name for certain businesses of JPMorgan Chase & Co. and JPMorgan Chase Bank, N.A., Member FDIC. The material contained herein is intended as a general market and/or economic commentary and is not intended to constitute financial or investment advice. Any views or opinions expressed herein by Al Brooks, are solely those of Al Brooks and do not reflect the views of and opinions of JPMorgan Chase & Co. or its affiliates. This information in no way constitutes J.P. Morgan research and should not be treated as such. Further, the views expressed herein may differ from that contained in JPMorgan Chase & Co. research reports. The information herein has been obtained from sources deemed to be reliable, but JPMorgan Chase makes no representation or warranty as to its accuracy or completeness.
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