October 18, 2023
In this edition, we synthesize the interplay between interest rates, prevailing uncertainty and recent bond yields, while highlighting the important things to keep in mind for CRE Capital Markets. In our Deeper Dive section, we dissect the yield curve and describe why the longer end of the curve has shifted higher.
- The most recent uptick in Treasuries acts as another force in tightening financial conditions and curtailing growth. At the same time, it’s given the Fed more ammunition to pause at their upcoming November meeting.
- That said, inflation remains too high, and the Fed’s conviction on reigning it in remains firm.
- We are seeing softening emerge in labor markets (wage growth is trending in the right direction), but September’s higher than expected CPI readings (particularly for Core Services) demonstrate that progress is going to be slower, choppier and harder-fought than it has been in getting from a peak of 9% y/y headline CPI to 3.7% y/y as of September 2023. Still, there were some encouraging signs out of CPI ex-shelter that point to further disinflation.
- Even as inflation comes in, the Fed will remain patient to ensure they see sustained progress. As a result, real yields will remain elevated, which will further curb growth for interest-rate sensitive areas of the economy (corporations, business investment, consumers, etc.), thus exerting additional pressure on the economy, eventually translating to job losses that will flow through to core inflation. This will prompt the Fed to consider rate cuts by mid-2024, paving the way for a renewed growth cycle in 2025.
KEY THEMES THIS WEEK
- The 10-year Treasury yield “10YT” has spiked 43 bps over the last month [Chart 1]. To put that level of volatility in context, 2023 has experienced approximately 18 days where 10YT has shifted more than 2 standard deviations. This level of volatility even mirrors 2022, when the Fed had just started its hiking cycle, and comes close to the degree of volatility seen during the GFC, as well during the 1980’s when inflation prompted the then Fed to undertake aggressive hiking cycles. [Chart 2]
- The volatility witnessed in the long-end of the yield curve acts as a further challenge to an already constrained CRE debt and capital markets environment because it adds to, and prolongs, uncertainty for lenders, investors and sellers.
- The volatility witnessed throughout longer-dated treasuries also sent the yield curve on a fluctuating journey. Yet, the yield curve remains inverted and points to impending recessionary conditions (tightened monetary policy takes time to flow through, and we’re facing a slow-burn credit cycle at the moment).
- While near- and medium-term fluctuations to the 10YT are underway, we recommend maintaining focus on the broader concept of interest rate normalization.
- From a level standpoint, we need to get used to the 10YT being around 4% or higher. The decade leading up to the pandemic was not the norm, nor was it sustainable. Even when the Fed pivots, whenever that is, the long-end of the curve won’t come back down to abnormally low levels (think fed funds at 2.5%, and 10YT at around 4% or higher assuming a ~150 bps spread).
- CRE risk spreads relative to risk-free benchmark rates and corporate bond spreads must adjust upward. We are in the midst of that adjustment period now. A lack of adjustment would have important implications for allocations to CRE relative to other alternative investments.
- Moving forward, two factors will drive the price discovery period and capital market revitalization. The first is stability in financial markets and interest rates, expected as macro policy and the economy stabilize. The second will likely be triggered by sellers facing liquidity needs, by those accepting to the new market “normal,” or those dealing with conditions like impending loan maturity or property-specific weaknesses requiring additional capital.
- As price discovery for necessity-based sell-side conditions prompt more activity, and as broader uncertainty fades (which it inevitably will), the market will reset and grow fluid.
- We’re already seeing several institutional investment managers reaching out proactively to position themselves ahead of that full inflection point.
- In the meantime, perspective is everything, and keeping a bigger-picture, yet simplified view of the complexities of the bond yields, of Treasury fluctuations and of the “higher-for-longer” misnomer is most important. Think normalization, not just a fleeting, finite period of “higher-for-longer” in forming your next investment strategies.
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