The Return of Interest Rates

It’s finally time to start talking about interest rates again. For the past five years interest rates have not even been in the economic conversation. But recent events in Europe, Asia and the US have brought interest rates and the interest rate policies of central banks around the world back to the forefront. Rising interest rates in the US will have an impact on the real estate sector most immediately in investment markets.

  • In Asia, the efforts to stimulate growth via bond purchases in Japan-one part of the set of policies that have been dubbed “Abenomics” after Prime Minister Shinzo Abe-has led to increased volatility in equity and currency markets and more importantly appears to be having a positive impact on Japan’s economy which grew more strongly than expected in the first quarter of the year.
  • In the US, recent indications by the Federal Reserve that it may start winding down it’s bond purchase program later this year has caused interest rates to abruptly increase leading to wide gyrations in equity markets and is forcing businesses and investors to start thinking about a world in which interest rates are no longer held artificially low.
  • In Europe, the European Central Bank (ECB) dropped the interbank lending rate to a record low in May to counter continuing economic weakness. Economic improvement in Europe is likely to take more time to fully emerge.

For most of the past five years, official interest rates have been held at or near record low levels as central banks in the developed nations sought to counter first the most severe recession since the Great Depression and then the weakest recovery on record. Market driven interest rates, particularly for 10-year government bonds have trended lower. But it wasn’t until 2011, when the Federal Reserve began to aggressively purchase long term bonds that long term interest rates in the US, followed by the UK and Australia, began to decline substantially. In China long term interest rates have held steady at between 3.5% and 4.5% as the government first sought to stimulate during the recession but quickly switched to a more restrictive policy as growth accelerated and fear of inflation increased. In the Euro Zone it was in mid-2012 that ECB President Mario Draghi told the world that he will do “whatever it takes” to preserve the Euro and support the nations in the currency union. Since then long term interest rates in Europe have moved sharply lower.

After all these years of low short term interest rates with longer term rates trending lower, the environment has shifted in the last six weeks or so. That’s when the Federal Reserve fist mentioned the possibility of reducing the amount of long term securities purchases (Treasury bonds and Mortgage securities). Since then, US interest rates have spiked higher. Long term treasuries are up from approximately 1.60% to 2.40%. This has caused long term bond rates to move higher in just about every major economy throughout Europe and even in Japan and led to an increase in volatility in global equity markets.

We are now in uncharted territory. After unprecedented and unorthodox policies were initiated to address the most challenging economic conditions in decades, financial markets are now facing uncertainty about how those policies will be unwound or how much longer they will stay in place. The first country to be facing these questions appears to be the US where the Federal Reserve is signaling that US economic growth is likely to get stronger and the risks to growth are diminishing. How the Fed will ultimately unwind its massive easing and the impact that will have on the economy are not clear. Higher interest rates could threaten growth and could make investors shift their strategy away from fixed income and other yield driven investments. However, the underlying reason for the potential shift is an improving economy and the Fed has been very clear that it will not raise rates prematurely and that it will continue to monitor economic performance and ease off if the economy appears to be faltering. The result is likely to be choppy investment markets but an improving underlying economy.

Elsewhere in the world, different monetary policy challenges are occurring.

  • In Europe, while there is some optimism that economic conditions will not deteriorate further, meaningful growth is unlikely until later this year. So the ECB is unlikely to make any changes in its policy for the foreseeable future. European financial markets will not be immune to volatility elsewhere in the world, but the challenges posed by the continuing weakness in the regional economy and the continuing debate/discussion about financial, banking and economic integration will likely result in a basically stable interest rate environment.
  • In Asia, the Bank of Japan is most likely to continue buying securities to keep rates low as the government continues to move ahead with other policy measures designed to stimulate growth. In China, slower growth (note “slow” in China means 7%) will likely lead to stable interest rates in the near term as the government balances the need to keep the economy growing while at the same time trying to keep inflation from accelerating.

For the real estate sector, the most direct impact of higher interest rates in the US will be on investment markets. It is unclear how investment markets will react to an increase in interest rates. While they will tend to make some investors reassess their strategy, the improvement in leasing fundamentals that accompanies these changes can make properties more attractive.

For the first time in many years, interest rates are an important factor in the economy and in global investment markets. There is likely to be some turmoil in financial markets and in real estate investment markets as the adjustment takes place, especially because the Fed has never embarked on this program before. But the reason the Fed is shifting and the reason that rates are likely to rise in the future is that the US economy is in much better shape and is growing more strongly. From a leasing perspective, this means employment is rising and demand for space is likely increasing as well. Stronger economic growth in the US will benefit the global economy. US demand for goods and services across the world will accelerate helping to boost economies in Europe and Asia. Each region has its own challenges and opportunities and a stronger US economy by itself cannot carry the rest of the world, but it will be an important support for the global economy.

The emerging new interest rate environment will create challenges and there will be bumps in the road. But stronger economic growth will enable global financial and real estate markets to absorb the changes in fixed income markets that are coming in the US.

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