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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   February 2015

Tracking the Next Big Move in Interest Rates

Historical and international perspectives are vital when analyzing rate trends

Now that the commercial mortgage industry can look at the recession through the rearview mirror, it’s apparent that the aftermath of the downturn brought with it far more upside than downside.

With cranes in the air and abounding new construction, the economic beacons signaling an expanding economy are as plain as day. Road repairs, highway construction and new residential skyscrapers dot the landscape. Companies are hiring again, as well as building and expanding factories. Banks seem to be overcoming their previous skittishness, and there’s been a substantial increase in commercial and industrial loans. These data points signal an economy on the mend, which generally goes hand in glove with rising interest rates.

With all this in mind, it’s clear that the 10-year Treasury rate will eventually rise; it’s not a question of if, but when. Mean reversion is a concept familiar to many, and it seems like rates have been below the mean for a number of years.

If you look a bit back in time, however, today’s low rates aren’t really such outliers. According to the fourth edition of A History of Interest Rates, the average rates in the ’30s, ’40s and ’50s were 2.98 percent, 2.54 percent and 2.99 percent, respectively. Along with keeping an eye on the state of the global economy, this kind of historical perspective can be enlightening for commercial mortgage originators, impacting not only their outlook for the years ahead but also the way in which they advise and evaluate their clients.

International considerations

Notwithstanding all the excitement about a rebounding economy, there are considerable headwinds keeping rates from rising meaningfully in the near term. First, the Federal Reserve is nervous about repeating its big mistake from 1937 — raising rates too early — and many historians agree that this triggered the second leg of the Great Depression.

Recent policy statements, including remarks by Federal Reserve Board Chair Janet Yellen, suggest that the Fed still sees plenty of slack in the labor markets and is reluctant to tap the brakes until more people return to work. The Fed’s go-to inflation measure — the Department of Commerce’s personal consumption expenditures price index — was up 1.4 percent year over year this past October and continued to run below the Fed’s 2 percent target.

Of perhaps greater significance, the United States belongs to a global economy, and interest rates are determined in part by the world’s other major central banks. U.S. rates, which are low in a historical context, are substantially above those of many major developed nations.

Europe faces serious challenges, of course, as evidenced by the free-fall in government-bond yields and this past summer’s 10 percent decline in Germany’s DAX stock market index. Germany’s ZEW index of economic expectations declined to 6.9 this past September from 8.6 in August, its lowest reading since December 2012. Germany’s gross domestic product (GDP) also shrank by 0.6 percent this past second quarter, its first decline since 2012. At the same time, low bond yields in countries such as Finland and France may be the canary in the coal mine for a triple-dip  European recession, suggesting that yields could remain low for the foreseeable future.

These issues aren’t exclusive to Europe. Japan’s  second-quarter ’14 GDP posted its greatest decline since 2011, when it dropped in the wake of the Fukushima nuclear incident. In China, government policies are causing banks to tone down their lending, a move likely to further crimp economic growth. All of these issues impact the U.S. and world economies; viewed through this prism, American rates may not seem so low after all.

Historical factors

In retrospect, it appears that the Fed’s zero interest rate policy weakened the U.S. dollar, which stimulated exports and boosted economic growth. Because the Fed isn’t operating in a vacuum, virtually all other developed countries’ central banks piggybacked on the Fed, adopting similar interest rate strategies.

Today, the tailwinds from the zero interest rate policy have effectively evaporated because many other countries have copied the Fed. A reverse move —  raising interest rates — will likely have an opposite effect on U.S. exports and economic growth, so the Fed will likely delay meaningful increases in rates as long as possible, or at least until it believes that other countries will follow.

Interest rates are one of the most important finance drivers in the economy. They determine companies’ borrowing costs and the cost of capital, and they establish investors’ return expectations. Stories abound about real estate investors being crushed when lenders foreclosed on their properties after interest rates moved higher and property cash flows didn’t keep pace with rising debt-service costs. On the flip side,  investors — and originators — with the right instincts about where rates are going may make a fortune.

Historically, rising interest rates are consistent with economic expansions. And as noted previously, the 10-year Treasury rate — an important indicator of interest rate trends — was under 2 percent at the beginning of this past January, comparatively lower than its long-term average (above 4.5 percent). It’s important to also note how drastically interest rates fluctuated in the 20th century, ranging from  2.99 percent in the ’50s to more than 10 percent in the ’80s. All this should illustrate one thing to commercial mortgage originators: When it comes to judging interest rates, perspective  is important.

Looking ahead

Rates will soar at some point — again, it’s a question of when, not if. When originators and other financial service  employees are convinced that the next big move in rates is up, however,  that can set the stage for surprises, one of which may be another year or two of comparatively low 10-year Treasury rates.

An even greater surprise would be a major downward move in the 10-year Treasury rate over several years. This move isn’t inconceivable to some financial experts; Hoisington Investment Management President Van Hoisington, for instance, recently said that U.S. 30-year yields could soon decline into the range of 1.7 percent to 2.3 percent, which is where the respective 30-year yields in the Japanese and German economies currently stand.

In any case, imagine the impact that this kind of market environment would have on investment strategies and commercial real estate transaction value and pricing. In light of that, to ensure their future success, commercial mortgage originators should carefully watch these economic developments, all the while maintaining historical and international perspective.


 
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