With Serafino Tobia, Head of CBMS Trading, Greystone
Looking back at the frequent rate increases of 2022 and 2023, and how the economy is today, do you expect that 2024 will be very different in terms of Fed moves?
Yes, 2024 will absolutely be a different for both the Federal Reserve and the interest rate market. 2023 had the Fed raising short term Fed Funds rates and selling Treasuries and MBS securities from its balance sheet (Quantitative Tightening, QT). Over the past two months, we have had a major pivot in interest rates already in anticipation of the Fed moving to a dovish monetary policy. 10-year rates moved lower by 23 basis points in December and lower by 54 basis points in November. The 10-year Treasury is now 4.04% from the recent high of 5.02% on November 23, a 98 basis point improvement.
The bond market is anticipating cuts in the Fed Funds rate over the next year, starting with a 0.25% reduction as early as March and as much as 1.50% lower by year end 2024. After the FOMC meeting in December, the Federal Reserve, with the Dot Plot (survey of the 19 Fed officials), indicated that the Fed Funds rate is likely to be 0.75% lower by year-end 2024 and the Fed could start rate cuts later than the bond market is anticipating – possibly waiting until the second half of 2024. In other words, all along the yield curve, the bond market is front running the Fed and we are not likely to get much more improvement in interest rates until the economic data confirms the improvement we’ve seen in rates over the past two and half months.
It seems that the Fed’s strategy on lowering inflation is working – with the CPI index peaking at 9.1% in summer 2022 and now 3.3% year-over-year as measured in December. How important is it that inflation decreases to 2%?
First, I wouldn’t say that the Fed’s strategy “is working” per se. To my thinking, Fed Chairman Powell was absolutely correct in that a major part of the inflation was transitory brought on by supply disruptions and higher demand for goods during the pandemic. It is just that the “transitory” correction and the supply shock has taken almost two years to abate (rather than a few months as Fed Chairman Powell had suggested originally). Fed monetary policy of raising the Fed Funds rate from near zero in early 2022 to a 5.25% - 5.50% range currently hasn’t had a noticeable impact on the economy; we still have near-full employment (current unemployment rate at 3.7%) and US domestic production is strong (US GDP grew 4.9% in the 3rd quarter 2023). Yes, Fed monetary policy is restrictive; it just hasn’t filtered through to the economy…so far. Arguably, if the Fed stays “higher for longer,” Fed policy, with its “long and variable lags,” will ultimately work on slowing the economy and push inflation further down as well.
I’m not expecting the Fed to wait until we have a 2% inflation rate to start reducing the Fed Funds rate. I do think we need to see considerable progress towards 2% inflation; possibly 2.5% +/- annualized inflation for a 4-5 month period would allow the Fed to start moving the Fed Funds rate lower.
The bond market is anticipating the first rate decrease of 2024 to occur in March – what factors do you think contribute to this thinking?
We had a string of consistently lower prints of the inflation rate. Top line Consumer Price Index (CPI) peaked in June 2022 at 9.1%, the November print for year-over-year CPI was 3.3%. Paul Krugman, New York Times economist, has dubbed this as “Immaculate Disinflation,” lower inflation without a recession. The markets are anticipating that this trend will continue and be sufficiently sustained to allow the Fed to start moving rates lower. Some market pundits argue that the bond market is too optimistic about further improvement in inflation and, without a recession, inflation will be “sticky” at around 3%.
Which data set do you think is most important in terms of ability to influence the Fed’s decisions? (i.e. jobs, CPI)
With regard to the level of interest rates and Federal Reserve monetary policy, inflation figures most prominently. While it is true that the Federal Reserve has a dual mandate – (1) to achieve maximum employment and (2) keep prices stable, we have a strong economy and arguably full employment. Fed policy has been hawkish, moving the short-term Fed Funds rate from near zero in March 2022 to 5.25%-5.50% range currently. The Fed is focused on bringing inflation down to its 2% target. I think that the Fed is willing to allow the unemployment rate to move to 4-4.25% in order to bring inflation down to its target. The unemployment rate is currently 3.7%, a near historic low and has been at sub-4% for the past 2 years.
How do you think the anticipation of lower rates this year will impact commercial real estate lending, against other factors like the slowdown in new construction?
Last year, commercial real estate lending was down as the real estate market grappled with interest rate hikes for most of the year. 1-month SOFR rates north of 5% pushed floating rate bridge loan mortgage rates to 8.50% - 9%+. Refinance activity dropped dramatically in 2023 with the higher rates (and after the refinance volume over the past few years when the Fed had interest rates near zero). Acquisition finance business was lower last year as well as property investors that had a strong bid for properties in 2021 and 2022 (and had financed with floating rate debt), pulled back on buying to focus more on dealing with the high cost of floating rate funding with their existing real estate portfolio. Additionally, less commercial properties changed hands last year as there was a mismatch between price and cap rate bids versus offers.
With 10-year rates having improved some 1.25% +/- since late October last year (both lower Treasuries and spreads), I am optimistic that perm financing activity picks up this year. Borrowers will be fixing-out floating rate debt into Agency permanent loans. However, for commercial real estate lending to reinvigorate, property acquisitions need to pick up. Property sellers will need to become more realistic with price and cap rates to reflect floating rate funding costs. A lower Fed Funds (and 30-day SOFR rate) will help; however, there is still a question about when the Fed will start cutting rates and by how much. The Fed hasn’t started moving rates lower as yet, and is on hold at this point with the Fed Funds rate target range at 5.25% - 5.50%.
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