Because real estate is such a highly capital-intensive business, the future direction of interest rates is always top of mind with lenders and developers. But a planned May 10 meeting of the Federal Open Market Committee is drawing more attention than usual. There is widespread anticipation that the Federal Reserve will raise the fed funds rate, charged on overnight loans between banks, another quarter point. Since June 2004, the fed funds rate has climbed from 1% to 4.75% as a result of 15 consecutive rate hikes.
Economist James F. Smith views the actions of the Federal Reserve since last September as a threat to the health of the U.S. economy. Why? While the Fed's strategy has been to bump up rates continually to ward off inflation, the frequency of the hikes, he says, has been excessive.
Smith is confident that the Fed will raise rates to 5% when it meets later this month. At that point, warns the chief economist with Parsec Financial Management in Asheville, N.C., “the clock will start ticking toward the next recession.” An astute observer of monetary policy, Smith's argument centers on the dreaded inverted yield curve, the point at which all short-term Treasuries yield more than longer-term Treasuries. History shows that when that scenario occurs, the economy inevitably begins to sputter a short time later.
“Come May 11, we will have a fully inverted Treasury yield curve,” predicts Smith. “Every time we have had a fully inverted Treasury yield curve since the Federal Reserve System was created on Dec. 23, 1913 — and the inverted yield curve has persisted for one month or longer — then within nine to 19 months the U.S. economy has gone into a recession.”
The sobering remarks from Smith came during a speech delivered to a group of multifamily executives gathered for a conference in Scottsdale, Ariz., in early April. The National Association of Home Builders hosted the event.
If Smith is correct, the economy could be falling into a recession as early as the middle part of 2007. That's the bad news, but what's the good news? “It should be a very short, very mild recession, very similar to 2001,” says Smith. He points out that overall GDP in the last recession declined only a half-percent, the mildest economic downturn ever in the history of the U.S.
Meanwhile, the combination of incremental increases in short-term rates and a growing economy is finally starting to push the 10-year Treasury yield substantially higher. In April, the 10-year yield breached 5%. “I'm not surprised that long-term interest rates bumped up all of a sudden,” says Bob Bach, senior vice president of research with brokerage Grubb & Ellis. “I'm more surprised that they stayed as low as they did for as long as they did.” If the 10-year Treasury yield remains below 5.5%, Bach sees no ill effects for commercial real estate. “Above that, we could see cap rates creeping up.”
It will be interesting in the months ahead to see how these interest rate movements come to bear on the real estate investment market.