U.S. real estate and capital markets update Q3 2021
Hedging and Capital Markets
Real Estate | Denver, CO
As we wind down on summer 2021, many Americans are returning to the office and sending their children back to school. We recently reviewed the effects of COVID-19 on the U.S. economy and takeaways for the real estate market during our semiannual market update webinar. On September 15, participants heard from two of our senior consultants, Adrian Ng and Jamie Macdonald, about their thoughts for the economic outlook, interest rates and interest rate risk management, and an update on IBOR transition.
Key takeaways from live polls of our audience:
- Audience members indicated that 41% were optimistic about not only the next 6–12 months, but also the next five years of economic conditions.
- Attendees were also asked to predict where the 10-year U.S. Treasury would be by the end of 2021. With the 10-year at ~1.29% during the webinar, it was not surprising that 43.8% of respondents expected it to finish the year between 1.25% and 1.50%.
- With 1-month USD LIBOR scheduled to no longer be published after June 30, 2023, we polled the audience on their readiness for the upcoming transition. Promisingly, only 5% of respondents said that they are “not prepared.”
- We asked audience members what the top-priority issue for their firm is over the next 1–2 years. The most common response was “hiring and retaining key players.” This may not come as a surprise, given the inflated resignation rate that U.S. companies have seen in 2021.
The U.S. experienced its shortest recession in history in 2020, which only lasted two months (according to the National Bureau of Economic Research, which defines a recession as the period between a peak of economic activity and its subsequent low point). Since the sharp dip in early 2020, we’ve seen a significant bounce back in most economic categories, which has resulted in a “V” shape recovery for the U.S. economy. Many economic indicators have reached or even surpassed their pre-pandemic peak. Leading indicators point to robust business investment and personal consumption. Furthermore, manufacturing PMI is sitting at 59.9, a very strong level which has followed an upward trend for the last 15 months.
Part of the recovery can be attributed to fiscal transfers in the form of stimulus checks from the U.S. government delivered directly to households and individuals. The graph below shows the sharp drop in real personal income excluding transfers and divergent total disposable income including transfers which illustrates the effect stimulus checks have had on personal income. Many view this overall increase in disposable income (driven by stimulus checks) as a key factor in the strong economic recovery that we’ve seen.
The effects of aggressive economic stimulus and Fed action have raised fears that inflation will continue to run rampant. We’ve seen price pressures across the entire basket of consumer goods, although some categories have been hit harder than others (energy, for example, has increased 23.8% year-over-year). The New York Federal Reserve runs a nationally representative survey of approximately 1,300 households to assess the country’s expectations of future inflation.
One takeaway from the survey (which is shown in the graph below) is that households expect inflation to continue to run hot for the next year at a 4.8% annualized rate. However, households expect the three-year ahead inflation rate to cool down to about 3.7% annually. We’ve often heard the Fed describe this period of inflation as “transitory,” however, this data suggests that households disagree. Could this be a case of recency bias or a trend of long-term price increases? While the Fed agrees that “inflation at these levels is a cause of concern, … that concern is tempered by a number of factors” (Fed Chair Jerome Powell).
In addition to price levels, the labor markets form the second part of the Fed’s dual policy mandate and will be another factor that will influence Fed policy decisions, including their timeline to taper, or discontinue bond purchases. Prior to the COVID-19 pandemic, labor markets were at the strongest point since before the Great Financial Crisis (GFC). During the pandemic, many Americans lost their jobs or saw their work hours reduced due to shutdowns or workforce reductions. Since the pre-pandemic peak in the summer of 2020, we’ve seen a strong bounce back in U.S. labor markets. In June and July of 2021, we saw a blistering gain of ~900,000 jobs per month. At this rate, it would take over six months to get back to the pre-pandemic peak of employment. Even at a strong pace of 400,000 jobs a month (which we saw in August 2021), it would take over a year to get back to the pre-pandemic peak. The graph below shows the unemployment rate by demographic, pre-pandemic and post-pandemic.
While labor markets are not back to pre-pandemic levels, we have still seen an unparalleled improvement. The graph below shows a stark difference between the recovery from the GFC and the recession of 2020. The current recovery has been far quicker compared to the slow grind in re-employment after the GFC. While this data is promising, the Fed remains cautious in its decision to start tapering. Ideally, we’ll see continued job growth in the U.S., which may lead the Fed to taper and slow the growth of its balance sheet.
What does all of this mean for commercial real estate financing and capital markets? If you are in the camp of sustained inflation, there could be a material increase in rates over the medium to long term. One common approach to protecting against a higher rate environment is forward hedging future fixed-rate debt. In this approach, real estate borrowers are able to enter into transactions today that will give them rate certainty or a known worst case fixed-rate borrowing at some point in the future. This approach is beneficial for borrowers who have an expected fixed-rate financing in the near term but want to protect against movements in rates between today and loan closing.
Since 2000, 5-year fixed rates have outperformed floating-rate debt over a corresponding 5-year period only 12% of the time. Meaning that during that period, borrowers would have been better off with 5-year floating-rate exposure over 88% of the time. In fact, 10-year fixed rates have never outperformed floating-rate debt over a corresponding 10-year period. These facts make sense when you look at the rate environment that the U.S. has experienced over the past decade.
Nevertheless, in periods when the Fed has historically tightened monetary policy and started raising rates (as we may see in the near future), fixed rates have outperformed floating-rate debt. Currently, the market expects the next rate hike to occur by December of 2022. At that point, the market prices in a ~53% probability of at least one rate hike — 36% probability of a 25 bps hike, 14% probability of 50 bps, and 3% probability of 75 bps. The graph below shows a historical distribution of the 10-year U.S. Treasury over the past 10 years. The current 10-year, ~1.29% (as of September 15), is sitting at the low end of the spectrum.
Understand your hedging strategies
Chatham assists real estate borrowers who are considering hedging future fixed-rate financings as well as broadly assessing financial risk exposures. If this seems like an attractive alternative to remaining exposed to future rate movements, please reach out to your Chatham contact. Additionally, you can view an on-demand recording of Chatham’s Semiannual Market Update for Real Estate by clicking below.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.21-0250
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