In a widely expected move, the Federal Reserve raised its interest rate target by 25 basis points on Wednesday. The Federal Open Market Committee (FOMC) voted unanimously in favor of the increase, which raises the target range for the federal funds rate to 0.50%-0.75%. This is the first policy change since the FOMC increased rates for the first time in eight years in December 2015.
All signs pointed to a rate hike, including strong signals from Janet Yellen and other Fed officials. The economy has continued to move closer to the FOMC’s objectives of full employment and stable 2% inflation in recent months, leading Fed officials to publicly suggest that a rate hike would be warranted. Investors were convinced as well, with futures markets indicating a 95% probability of an increase ahead of the two-day meeting.
The election of Donald Trump as the next U.S. president, combined with Republican control of Congress, has caused many economists to revise their near-term growth projections upward. The Fed has not materially changed its economic outlook, though the new projections reveal a slightly more optimistic view of GDP growth and unemployment in the next few years. Their interest rate outlook also changed slightly; the FOMC members now expect three interest rate increases in 2017, up from two as of September’s meeting. The absence of a significantly changed outlook affirms the Fed’s commitment to “data dependence” and aversion to speculating on the Trump administration’s policies. Fed Chair Yellen is a proponent of expansionary fiscal policy, which would ease the reliance on monetary policy to spur growth.
The public markets have reacted favorably to the election as evidenced by the series of record closes in the stock market and the rapid expansion of yields in the bond market. Treasury yields are up more than 60 basis points since Election Day. This increase in bond yields could give the Fed cause to take short-term rates higher down the road, as it will be less concerned about inverting the yield curve. Importantly, this would provide needed room to lower rates if and when the next recession hits.
Because of this recent run-up in long-term interest rates and the certainty with which markets priced in the Fed’s December move, we expect limited reaction in capital markets to this 25 bps increase. While commercial real estate capital values typically are sensitive to higher rates, most transactions are going under contract or closing at originally agreed upon terms, though some transactions have re-traded, particularly in highly leveraged transactions. The debt markets have shown somewhat more movement, including higher loan costs, lower LTVs, delayed refinancing and some buyers moving down the yield curve to lower all-in rates.
These sales and debt capital market movements are early indicators rather than trends. U.S. CRE fundamentals remain healthy and investment into the sector continues to be strong. Rising interest rates don’t necessarily lead to rising cap rates, especially in the short term. Given that the U.S. remains a magnet for global capital, cross-border capital flows could offset some domestic softening in cap rates.
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