Rising yields and a steepening curve — U.S.

Many have read the rising yields and steeper yield curve as optimism about the economic recovery. There are justifications for this view. With the Biden presidency, a Democratic-controlled House, and gains by the Democratic Party in the Senate after the Georgia runoff, a large fiscal package of around $1.9 trillion is expected. Treasury Secretary Janet Yellen supports continued fiscal stimulus. COVID-19 hospitalization rates and deaths have fallen sharply, and over 14% of the population has received at least one dose of the vaccine. Vaccine trial results have surpassed expectations and Israel’s experience has been encouraging, notwithstanding cases of adverse side effects. The U.S. unemployment rate (BLS civilian unemployment rate) fell to 6.3% in January 2021, down from 14.8% in April 2020. The Conference Board’s U.S. Economic Indicators are broadly positive, with consumer confidence up 2.4% and measure of CEO confidence up 9 points. The S&P 500 is at all-time highs, oil above $60 per barrel is higher than 2018-2019 average, copper has almost doubled from the March 2020 low, and the Drewry WCI Freight Benchmark Rate per 40 Foot Box has risen sharply over the past three months.¹ New orders for manufactured durable goods beat expectations with a 3.4% increase and increased for nine consecutive months

Prominent economists like Larry Summers and Olivier Blanchard have expressed concern about the fiscal package. Summers wrote, “We must make sure that it is enacted in a way that neither threatens future inflation and financial stability nor our ability to build back better through public investment.” He would like a substantial portion to be directed at “promoting sustainable and inclusive economic growth for the remainder of the decade and beyond, not simply supporting incomes this year and next.” Blanchard, looking at the output gap and multipliers, noted that an excessively large package can cause the economy to overheat. While Yellen acknowledged that risk, she stressed that the “huge economic challenge here and tremendous suffering” is the “biggest risk.” At the moment, both current and forward-looking data are not alarming. The PCE price index, one of the Fed’s preferred measures of inflationary pressures, rose 1.5% year-over-year in January 2021, broadly in line with expectations. The 10-year breakeven inflation rate was at 2.14% on February 25 and the 2-year breakeven inflation rate was around 2.5% — an indication perhaps of near-term inflationary pressures while long-term inflation expectations remain anchored.

The path from stimulus to inflation is not a given. While low-income households typically have a high propensity to spend, many others may save the stimulus checks or repay debt, including overdue rents. For corporations and financial institutions, capital staying on the balance sheet means “velocity” (i.e., the circulation of money in the economy) is limited and spending is less than desired. In any event, a boost to demand may not produce sustained increases in prices if supply can adjust. Businesses raise prices when they cannot keep up with supply and do not fear losing customers to competitors. If businesses can quickly hire, source inputs, and increase production to meet the expected bump in demand, then we may not see large, widespread, sustained price increases. According to BLS, seven million people are not in the labor force but want a job while the employment-population is 57.5% — both indicators are generally worse than pre-pandemic levels over 20 years. The labor market is far from tight and in such a scenario, we do not expect wage pressures either.

A vigorous economic rebound itself is not a forgone conclusion. Will business travel rebound to pre-pandemic levels? When lockdown restrictions ease and the hospitality industry reverts to pre-pandemic semblance, how much “deferred spending” (meals out, vacations, shows, etc.) can we realistically expect from consumers? With the labor market still in recovery, it remains to be seen how much pent-up demand would come through. According to Fed Chair Jerome Powell, “we are a long way from such a labor market” that would heal “the entrenched damage inflicted by past recessions on individuals' economic and personal well-being.” The Fed warned that historically high commercial real estate prices “appear susceptible to sharp declines” while business leverage “now stands near historical highs” — vulnerabilities that should not be ignored.

The Fed has repeatedly stressed that it will stay accommodative. When the Fed updated its framework and adopted flexible average inflation targeting last year, it made a strong commitment to robust labor markets. The Fed wants the fruits of economic growth to be more broadly shared across socio-demographic groups. For Chair Powell, employment as of January 2021 was still about 10 million below the February 2020 level, “a greater shortfall than the worst of the Great Recession's aftermath.” Unemployment rates seem to understate the damage to labor markets. After correcting misclassifications and counting those who exited labor force as unemployed, Powell would put the unemployment rate at around 10% instead. Despite the rise in yields and steeper yield curve, markets are not expecting the Fed to raise rates in the immediate future. Further, after seeing the “taper tantrum” of 2013 and the volatility in SOFR in 2018, the Fed is expected to pull back quantitative easing more slowly and carefully. For now, the probability of a rate hike before year-end has stayed broadly unchanged while a full rate hike is priced for mid-2023.²

A major risk for CRE investors is that they assume rates will stay low for long and decide to de-prioritize managing interest rate risks. As the economy recovers and long-term yields rise, credit spreads have compressed, causing all-in rates to stay roughly the same — this may have added to the complacency. Given how much and how quickly long-duration yields have risen, they may not want to take their eyes completely off.

At the same time, CRE investors should be mindful of the opposite risk: rushing headlong into fixing long-duration rates. Based on historical data since 2000, 2-year fixed rates outperformed staying floating over corresponding 2-year periods about 28% of the time. 5-year fixed rates outperformed staying floating over corresponding 5-year periods 12% of the time. Historically, fixed rates outperformed staying floating when the Fed normalized monetary policy and started raising rates, with markets generally underpricing either the pace or the extent of the rate hikes. 10-year fixed rates have never outperformed staying floating over corresponding 10-year periods. Neither have 5-year forward-starting 5-year swaps. Fixed rates (fixed-rate loans, interest rate swaps) can lead to volatility in valuation and/or material breakage costs.

How should CRE investors thread the needle, being neither complacent about rates nor rashly locking down rates? Sound risk management is not mechanical. Should I fix or float? Should I swap or buy a cap? These are fair questions, but we always advise investors to consider the property itself, the overall portfolio of assets and leverage, the desired mix of fixed and floating in the portfolio relative to asset income expectations, and the broader industry as well. The context is critical for properly making sense of rising yields and a steeper yield curve and arriving at an appropriate decision.

¹ Bloomberg

² Bloomberg Intelligence, Economic Optimism Hitting Some of Swaps & Swaptions, February 19, 2021