On June 14, the FOMC voted to raise the target range for the federal funds rate to 1% to 1.25%. Board member Neel Kashkari was the the sole member to vote against the increase, preferring to maintain what had been the existing target range for the federal funds rate. More unexpected was the Fed’s decision to begin shedding securities assets, the ramifications of which the commercial real estate (CRE) industry will have to wait to see play out.
“The risk here is that as the Fed starts unwinding their balance sheet, it creates competition for capital with lenders needing to raise their rates to attract investors. This said, it won’t happen all at once and it is going to be a slow process,” says Jim Costello, senior vice president at real estate research firm Real Capital Analytics.
Logically, the cost of borrowing should increase, but the CRE sector has largely anticipated this hike, and already priced the quarter-point increase into deals.
Steve Hovland, director of research for Irvine, CA-based online investment management platform HomeUnion, says the markets had anticipated a June interest rate hike. But he says this bump “marks a significant shift in the Fed’s mentality that the economy is strong enough to absorb interest rate hikes.” The Fed had sufficient justification to kick the can down the road following May’s weak employment gains, according to Hovland. Now, “we’ve certainly seen a shift where the Fed needs serious evidence to flatten the current trajectory,” he says.
“The FOMC realizes the window to normalize interest rates prior to the next recession is closing,” Hovland notes.
“Given that this was a well-telegraphed move by the Fed, capital markets will likely react with a fair degree of calm,” note Spencer G. Levy, Americas head of research, and Jeff Havsy, chief economist, of commercial real estate services firm CBRE. “Overall, no one should have been surprised by today’s move, as Fed officials did a good job of communicating their intentions in recent weeks…Going forward, wage and inflation data will be particularly influential, as will legislative progress on fiscal policy.”
The Fed’s median projection for the federal funds rate is 1.4 percent at the end of 2017; 2.1 percent at the end of 2018; and 2.9 percent at the end of 2019.
Should rates rise further, property performance fundamentals will become more crucial to pricing as yields are chipped away. Higher interest rates could also further stent construction lending.
But interest rates are just one of a handful of macroeconomic matters that investors are watching. This year, the CRE sector has moved into an environment of tempered transaction volume, and not just because of interest rates. A bid-ask gap between buyers and sellers, formed by high asset-pricing this cycle, has factored into 2017 seeing less investment volume year-over-year.
Waiting to Normalize
The Fed released plans for normalizing its balance sheet without a timeline for when that process would begin. As the plan applies to agency debt and mortgage-backed securities, the Federal Reserve says it anticipates an $4B-per-month cap that will increase quarterly, to reach a $20B cap after 12 months. In unloading principal payments received by Treasury securities, FOMC anticipates a $6B-per-month cap to increase quarterly so that by month 12, the cap reaches $30B.
“Fundamentally, the Fed is going to move slowly and cautiously with asset sales. They do not want to upset the apple cart,” Costello says.
It would be apt for the Fed to avoid flooding the market with too many debt instruments. Should that happen, it could “raise the long end of the yield curve and push up borrowing costs to a degree that hampers residential and corporate borrowing,” Costello says.
The Fed plans to start selling assets from their balance sheet very slowly. In fact they won’t sell anything at first but simply let expiring instruments mature without re-investing the capital back into the debt markets as they had been.
That move could potentially increase the long-term interest rate. CBRE researchers note the Fed currently holds $2.5T in U.S. Treasurys and $1.8T in mortgage-backed securities.
Regarding its reserve balance, The Fed said it is seeking to hold “no more securities than necessary to implement monetary policy efficiently and effectively.”
Whether the Fed has administered effective monetary policy over the past year has been increasingly in debate. Some economists have expressed doubts about the strength of the economy, following weaker inflation data. Markets anticipated May CPI readings would be flat, but on June 14, BLS reported the CPI had instead declined .1%, dragged down by the energy sector.
Counting on the Jobs
Though Chairwoman Yellen acknowledged “softer recent inflation readings,” she repeatedly referenced a “tight” labor market as basis to raise rates.
“With respect to recent readings, it’s important not to overreact to a few readings, and data on inflation can be noisy,” Yellen said when questioned about the data showing inflation hovering below 2%.
Although Yellen stressed the FOMC remains “attentive” to the fact that inflation is running below 2%, she said the Committee expects inflation to remain low in the near term, and that “with a strong labor market and a labor market that is continuing to strengthen, the conditions are in place for inflation to move up.”
Financial Regulation and Market Perception
Yet Yellen contended she didn’t see much evidence that the expectation of monetary policy changes had driven substantial change to consumer or investment spending. “Many of our business contacts, I think their confidence remains high. They have not really changed their plans yet, and they have a wait-and-see attitude,” she said.
Yellen cited the health of small community banks as a sign that Dodd-Frank has not restricted commercial lending, and said undercapitalization of banks impedes their credit growth. But she nevertheless cautioned against over-regulation, referring to implementation of the Volcker Rule as “frankly complex,” and adding she was open to looking at ways to reduce “regulatory burden” in that area.
“Regulatory burden, when it’s possible to ease it…that is something that all regulators should be looking to do. We strongly believe in the importance of tailoring our regulation to the size and complexity of institutions, of finding ways to relieve burden for community banks,” Yellen said. “We have been focused and had a number of initiatives already in that direction, looking for ways, for example, to simplify capital requirements for community banks, and will continue in that direction.”