Interest Rate Market Perspective – October 2015
October 1, 2015
“In my mind I say, put the ball on the court, don’t think about Serena. Try to put all the balls on the court … and run! …. Put the ball and run, don’t think and run, and then I won!”
Roberta Vinci Interview after US Open tennis match with Serena Williams, September 9, 2015
First, The Fed
How does Roberta Vinci’s quote relate to interest rates, you ask? We’ll get to that later (see “Back to Fundamentals” below).
First, the Fed…The Federal Open Market Committee (FOMC) met September 17th and decided to keep the Fed Funds Rate target at 0%…for the time being. Most investors and traders think it was a close call to not start raising the Fed Funds Rate; certainly the Fed wants to normalize the Fed Funds Rate, which has been held at 0% since December 2008 (originally reduced to 0% as part of the emergency stimulus to the financial crisis). Looking at just the employment, economic growth and inflation picture in the US, the Fed would have probably raising interest rates last week.
At the press conference after the meeting, Fed Chairwoman Janet Yellen pointed out that the labor market is close to full employment and that inflation should move towards the Fed’s 2% target rate over the next few years. The Fed continues to signal the lift-off from zero before year-end 2015. However, with the announcement, Fed officials expressed concern about overseas events and concern about inflation running too low. The key sentence in the FMOC statement last week is that “recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation over the near term.” In other words, turmoil overseas, especially the economic slowdown in China, may well limit the demand for US exports and bring on deflationary pressure.
The Fed is still confident that the troubles overseas won’t change the trajectory of the US economy that significantly. With the delay in lift-off until later this year, the Fed continues to project increases in the Fed Funds rate in 2016 and 2017 (as measured by the “dot plot”). The Fed introduced the concept of the “dot plot” in March 2015 that shows what the 17 Federal Reserve officials forecast for the Fed Funds rate. The new dot plot projects just one 0.25% increase between now and the end of 2015, followed by four increases in each of the next two years. The dot plot projects the Fed Funds at 0.375% by year end 2015 (0.625% was anticipated by year-end after the FOMC June 2015 meeting). The average level for year-end 2016 is now 1.375% (vs 1.625% projected after the June FOMC meeting). The average for 2017 is 2.625% (vs. 2.875% forecast in June). The average projection for 2018 is 3.338%. Again, these projections reflect an expectation of a growing economy with stable employment.
Bad News is Good News for the Bond Markets
I suspect the Fed was hoping that by postponing the lift-off from zero, they were easing market concerns about moving too quickly. Instead, the further delay served to raise concerns about China and the markets, validating the severe market volatility from August 2015. These concerns have pushed down Treasury yields and mortgage rates. Prior to the Fed announcement (9/17), the 10-year Treasury was at 2.29%; as of the close of business on Friday 9/18, the 10-year Treasury yields was at 2.13%, 16 basis points lower. There was a corresponding decrease in mortgage rates as well. Recognize also, over the same two days, the Dow Jones Industrial Average was down 2.12%, 355 points lower.
As discussed in the last article on the Fed Funds Rate Lift-Off (Interest Rate Market Perspective, June 2015), Fed policy and its opinion influences inflation expectations and long term bond and mortgage rates. Last week, the bond market reacted to the FMOC’s added language regarding “recent global economic and financial developments” that are likely “to put further downward pressure on inflation in the near term.” More recently, we are starting to hear further comments from Fed officials putting forward a positive spin on the delay and a positive expectation for the US economy to make the case for lift-off later in 2015. Other things being equal, positive “jawboning” by Fed officials will serve to calm the stock market and hold interest rates (around 2.25% on the 10 year Treasury) or slightly higher.
Back to Fundamentals
In the big picture, it doesn’t matter much whether the Fed starts raising interest rates now, in October or in December. It seems to me that there are headwinds to contend with over the next few years. If you believe the Fed’s dot plot has any significance, the Fed Funds Rate will start moving higher shortly and will be at 3% plus by year-end 2018. I’m asked from time to time by borrowers and investors if they should wait for a better market to rate-lock and invest. It’s my view to keep the focus on the fundamentals of the business model — if the yield works, the property investment ROE meets the required hurdle rate, “put the ball on the court and run!” While it is also possible the overseas economies deteriorate further and/or the US economy falters forcing the Fed to hold off or move slower, holding off to squeeze-out a few extra basis points can work for you or against you. With 10-year Treasuries below 2.25%, “don’t think about Serena;” this is a good time to lock-in long term rates and “win.”
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