Buffeted by the crisis in Japan, the escalation of armed conflict in Libya and geopolitical instability across the rest of the Middle East and North Africa, investors have been returning to the safety of U.S. treasuries. An uptick in demand for the 10-year note has cut yields by roughly 50 basis points since early February, to just over 3.4 percent as of last Friday.
For many investors, the current decline in long-term interest rates has tempered recent concerns that rising risk-free returns might exert upward pressure on cap rates and financing costs, dampening the momentum in commercial property markets.
These investors should be careful to avoid falling into complacency. While an abrupt and unexpected confluence of globally significant events has bridled the rise in long-term treasuries, an environment of rising interest rates may quickly reassert itself once macro conditions normalize.
Before the Latest Shocks, a Mutable Market
In late 2008, the global financial crisis was fueling enormous demand for treasuries. During the harrowing final months of that year, the yield on 10-year notes plummeted to just 2.1 percent. Rates then increased over the course of 2009, as policy interventions restored a modest degree of confidence in the financial system and the economic recovery commenced.
By early 2010, the consensus forecast showed that rates would soon surpass 4 percent. In its January 2010 forecast, for example, Fannie Mae projected that rates would rise to 4.2 percent by June, and to 4.4 percent by the end of the year. In the White House budget proposal for fiscal year 2011, released in early February 2010, the Office of Management and Budget projected that 10-year rates would average 3.9 percent in 2010 before rising to 4.5 percent in 2011.
The ensuing sovereign debt crisis in Europe, first taking hold in Greece and leading to the creation of the European Financial Stability Fund in May 2010, contributed significantly to the upending of confidence in the nascent global recovery. Even after large-scale interventions by the European Union and the International Monetary Fund, concerns about stability on the continent and the global implications of a sovereign default persisted. Risk-averse investors were drawn back to the relative safe haven of U.S. government securities, and treasury rates began to slide back. By late October of last year, deteriorating fiscal conditions in Ireland were threatening Europe’s unified position on the management of its debt crisis, pushing treasuries toward the historic lows from two years before.
In the months that have followed, as the immediate threat of sovereign defaults has abated, the improving outlook for the American economy and investors’ returning appetite for risk have pressed treasuries higher once again. Between last October and early February, yields rose by more than 130 basis points, peaking at 3.7 percent. All things equal, and under normal circumstances, such an abrupt increase in the risk-free rate would be observable in upward pressure on cap rates and commercial mortgage rates.
But far removed from normal circumstances, and with cap-rate and mortgage-rate spreads over treasuries significantly higher than their long-term averages, commercial property pricing metrics and financing costs have generally held steady even as residential mortgage rates have trended higher. The weight of investor demand for commercial properties has dominated headwinds from rising risk-free rates.
The Price of Stability
Rates have fallen in February and March because of new uncertainties presented by the disaster in Japan and events in the Middle East and North Africa. As those uncertainties are clarified, and barring a broadening of armed conflict, the appeal of treasuries will diminish significantly. Prices will fall and rates will resume their upward path, even if policy makers seek to maintain an accommodative environment.
In its official policy statement following its March meeting last week, the Federal Open Market Committee indicated that it will hold the line on short-term rates. Discounting the potential for sustained inflationary pressures, the FOMC offered that “… economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.”
But unlike the short-term target rate, long-term rates are subject to the vagaries of a market over which the Fed exerts more limited and less direct influence. Apart from an easing of threats to global stability, yields on long-dated government bonds will rise in correspondence with the economic outlook, responding to favorable policy developments such as the extension of tax cuts and data consistent with hiring gains. Job growth is the most desirable circumstance under which rates will rise, because it also implies that property fundamentals are generally improving.
Apart from an improving economic outlook, an increase in expected inflation will positively impact treasury rates. This is a concern now because of volatile energy prices that threaten to unanchor inflation expectations. Rates will also rise on an increase in treasury issuance or an increase in investor risk tolerance that saps demand for low-risk, low-return assets. Specific to our current circumstances, the end of quantitative easing and the disposition of assets from the Fed’s balance sheet could dramatically alter the interest rate outlook, requiring that rates climb well above the levels captured in lender and bond investor stress tests.
The Outlook
The baseline outlook for long-term interest rates remains manageable. In the March Wall Street Journal Economic Forecasting Survey, participants projected that rates would reach only 4 percent at the end of 2011. Only one participant anticipates that rates will rise to 5 percent.
In markets where cap rates and mortgage financing costs are elevated, modest increases in treasury rates are unlikely to be unsettling to commercial property investment trends. But in the region above each forecaster’s baseline outlook for treasuries, pressures on cap rates and comparable-term lending rates will be more apparent. In markets where spreads have already narrowed-and where investors are already most enthusiastic–the challenge from rising interest rates will be particularly acute if fundamentals gains remain lackluster.
Sam Chandan, Ph.D., is global chief economist of Real Capital Analytics and an adjunct professor at the Wharton School.
