Primarily due to concerns over short-term economic weakness and potential deflation, the Fed recently implemented the controversial QE2, the second round of quantitative easing. Over the past year, prices for all goods rose a meager 1.1%, and core inflation, which excludes the volatile food and energy sectors, inched up 0.8%. Most of these increases occurred before July.
Since July, core inflation has increased by only 0.1%. While certain goods and services have indeed witnessed large increases, notably gasoline, which has increased 7.3% in the past 12 months, and medical care, which has jumped 3.2%, these gains have been offset by flat or negative growth for other goods and services.
For example, there has been no growth in the housing sector, -0.8% downturn for apparel, and -4% for computers. One of the biggest components of inflation is wage pressure and because of high unemployment, there is none and that is one of the major reasons the Fed acted. A drop in housing costs has also helped, as has aggressive pricing by retailers of consumer goods.
Yield curves for one-, two- and even three-year Treasury Bills remain exceptionally low, reflecting little concern over short-term inflation. Currently, yield curves are in the 0.3% to 1.08% range, whereas in 1990, one- to three-year T-Bills were in the 8% to 9% range; and in 2000 they were in the high 5% range. In the past two months, however, interest rates on 10-year T-Bills have spiked 94 basis points to 3.53%.
The rise in long-term rates is due to expectations for faster growth in 2011. Better-than-expected readings on multiple economic indicators, the proposal to extend Bush-era tax cuts and other proposals by the Obama Administration to stimulate the economy, such as the payroll tax reduction, have prompted this shift in sentiment. This shift also reflects the desired outcome by the Fed to encourage capital rotation out of safety and into asset investments. Nonetheless, interest-rate movements and recovery patterns seldom move in straight lines, especially in this recovery. Another round of European debt concerns, negative surprises on banking and foreclosures and disappointing hiring in the United States could easily spur a temporary reversal in interest rates. The longer-term implications of the Fed’s QE2 and tax extensions are serious, and could negatively impact confidence and interest rates down the line.
Over the next nine months, the 10-year Treasury yield should settle in the 3.5% to 4% range, which is still low by historical standards. Interest rates are unlikely to rise much beyond this range, partly because of low inflation and the Fed’s commitment to purchase $600 billion in Treasuries next year. In a way, QE2 can be characterized as insurance to limit the rise in rates and support short-term economic momentum.
Longer term, once the economy and job creation pick up momentum, the Fed must move swiftly to remove excess liquidity from the system to fight off inflation early, without killing the recovery. This will be a delicate balance to strike since the markets are looking for “just-in-time” deficit reduction measures that do not cause a recession or stagnation.
Interest rates will rise again in late 2011 or early 2012, as the recovery turns into an economic expansion. Assuming an inflation run-up is avoided and deficit reduction plans are executed effectively, the rise in interest rates should be orderly, and within a reasonable range so as not to pose a significant valuation risk to commercial real estate. This is a big assumption that carries substantial risks, but the Fed has the benefit of past cycles – the 1994 and 2002 through 2004 cycles – both of which were extremes; with one nearly causing a recession, and the other creating a severe housing bubble.
The underpinning of a favorable outcome for today’s investors is locking in still low interest rates ahead of above-average rent growth. This requires realistic asset-specific underwriting, achievable rent growth assumptions and a cap rate spread that accommodates for higher, but not hyper interest rates.
Source: GlobeSt.com
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