All eyes will be on Washington and the Federal Reserve’s Open Market Committee meeting next week when the first cut in US interest rates for 11 years is expected. If and when this happens it will confirm a move in expectations towards ‘lower for longer’ interest rates that has been evident all year. CBRE’s Neil Blake and Pierre-Edouard Boudot discuss why this is happening and what it means for real estate investor.
- The Federal Reservice is expected to cut US short-term interest rates by 25bps at its end-July meeting. Long-term interest rates have already fallen substantially in most countries and expectations of where interest rates will be in the future have also come down.
- For investors, ‘lower for longer’ means that the threat of big capital losses from interest rate ‘normalisation’ looks rather more remote. Conversely, ‘lower for longer’ opens up the possibility of further yield compression.
- This means that the search for yield is not going to get any easier any time soon.
- Lower borrowing costs will make higher leverage more popular as investors seek to compensate for lower income returns.
US Interest Rates are on their way down
What a difference six months can make! The Federal Reserve’s Open Market Committee is widely expected to cut the Fed Funds target rate by 25bps at its end-July meeting. This will be another step in a remarkable about-turn in interest rate expectations over the past six months.
The Yield on US 10-year Treasury bonds (Treasuries) is a commonly followed indicator of long-term risk-free borrowing costs in the US. At the end of December 2018, the yield on 10-year US Treasuries was 2.7% having been over 3.2% occasionally in October and November. The consensus forecast was that they would rise to 3.5% by the end of this year. Now yields are 2.05% and they briefly fell below 2% earlier in the month. The Fed Funds rates is the US policy rate and is a much-watched benchmark for US short-term borrowing costs. In December last year, the Federal Reserve increased Fed Funds Rate from 2.25% to 2.5% – with talk of how quickly the next hike would be. There is now intense speculation about how much the Fed will cut rates at its July meeting.
Figure 1: 10 Year Government Bond Yields
Likewise, in the Euro area, the ECBs Quantitative Easing (QE) programme ended, the talk was of QE reversal (or Quantitative Tightening) and when in 2019 the ECB’s policy rates would rise (what would have been the first rise since 2011). At the end of 2018, 10-year German bund yields were 0.24% and were expected to increase to 0.8% by the end of this year. They are now hovering around -0.35%, an all time low. In the UK, as recently as May, the market had been predicting a 25bps rise in short-rates within the next year – now it does not expect that kind of increase for several years and the talk is of the next cut. Across the world government bond yields have fallen back and in some cases policy rates have been cut too.
These are significant changes. What this means for investors depends on two things:
- Why rates have come down
- How long will they stay down for
The main reason interest rates have come down is that expectations of economic growth and inflation have fallen back. Investors should temper their glee at lower rates. Weaker economic growth and lower inflation will impact future income from investments and offset, the impact of lower rates.
‘Lower for Longer’
But there might be more to it than that. Economic growth and inflation expectations have also come down because central banks (especially the Fed) were too hawkish in thinking that they could ‘normalise’ monetary policy and interest rates back towards pre-Global Financial Crisis (GFC) levels. Markets now think that the economy is fragile in the face of monetary policy tightening, or even the threat of it, and the threat of rising inflation was probably never there anyway. Put another way, the natural rate of interest is now much lower, both than it used to be and than US policy makers thought it was. The US 10 year T.Bond yields never moved up as much as the Fed Funds rate (leading to the current inverted or near inverted yield curve – depending on which measure you look at). In a sense, it looks like the market always had an inkling of the true state of the economy and the Fed has found that it can’t buck the market.
This is not just about US markets. International bond markets are all linked. What happened in the US tells us not just about the US, but something about international monetary and economic conditions.
This brings us to where interest rates go from here. If interest rates are low because of temporary factors such as unusually loose monetary policy or a cyclical downturn (the two can go together) then they will re-bound when things normalize. If rates are low because of a structural change (a lower natural rate of interest and/or a global savings glut) then they might not rise back to where they were. We think that the current situation is a mixture of the two.
Why are interest rates low?
So, what is the rationale for lower for longer interest rates? Part of it is about low inflation. The late cycle phenomena of shrinking capacity and rising prices has just not happened this time around. Despite record, or near record, low unemployment in many developed economies, wage inflation is moderate. Labour markets have been made more flexible, new jobs are in small, less unionized service companies (including the gig economy). Part comes the functioning of the goods and services markets (such as the development of e-commerce, still strong competition from emerging countries and de-regulation). It is also noticeable that the economy has not managed to get as far from its underlying trend (the output gap) than it has in many previous cycles (in other words, economic growth has been unusually weak in the upswing of the current economic cycle).
Inflation may only come back with a change in labour markets, a sustained period of more rapid economic growth or a reversal of the globalisation process. Even a hike in oil prices would not turn into a permeant increase in inflation unless labour and product markets enable workers to bid up wages and companies to pass on costs.
Low inflation is a reason why nominal interest (i.e. actual) rates are low but real interest rates are low too (negative in many cases). Real interest rates are nominal (or actual) interest rates less expected inflation. The main reason for this is a global savings glut. Put simply, savers are generating more savings globally than companies and others can make use of. The result is that real long-term interest rates are bid down. The high level of savings are due to a combination of circumstances: baby boomers and Gen-Xers saving for retirement in the west and an emerging middle class in the peak savings age groups in emerging economies. This might not last forever, but demographic projections imply that it has well over a decade to go.
Where does all of this leave us?
Long-term interest rates are low and much lower than many economists and policy makers thought they would be only six months, or so, ago. They will not stay this low forever, but long-term consensus forecasts have been lowered as more and more economists and policy makers are coming around to our way of thinking (that the underlying ‘equilibrium’ rate of interest is lower than previously thought). There are risks but the ‘lower for longer’ strap line looks like it will apply for some time.
Figure 2: European Prime Office Yields and Interest Rates
Source: CBRE, Macrobond. Major markets excluding Moscow and Istanbul weighted by market size.
Interest rate changes are important for investors because the drop in property yields since 2009 has been associated with falling long-term interest rates. For investors, ‘lower for longer’ means that the threat of big capital losses from interest rate ‘normalisation’ looks rather more remote. Yield-interest rate spreads are high and if the threat of higher interest rates is seen to have receded, further yield compression may be on the way. But how this ‘lower for longer’ scenario impacts on investment strategies is more complex.
On one hand, lower exit yields can be factored in but, on the other hand, income returns will stay low, more so as subdued inflation will not support significant rental growth. This means that the search for yield will not be getting easier for some time. In this scenario, investors could be tempted to improve IRRs through an increased use of leverage. The reason why leverage has remained moderate until now is a combination of risk aversion or expectations of a rapid rise in interest rates. Risk aversion will remain, but the dangers expectations of rising interest rates are evaporating. On balance, this points to rising leverage and stable or even compressing yields.