Market Matters: Exploring Real Estate Investment Conditions & Trends

NOV 20 EDITION  |  OCT 17 EDITION  |  SEPT 19 EDITION  |  AUG 24 EDITION  |  AUG 2 EDITION 

NOVEMBER 20 EDITION

QUICK BITES 

• Progress made, but not mission accomplished: the labor market is softening, and October’s CPI print provided the Fed with encouraging evidence that inflation is trending in the right direction. With key measures of both wage growth and inflation still trending above target, look for the Fed to signal a cautious, yet data dependent stance.  
• The tightening cycle is likely complete: While the Fed has left plenty of flexibility on the table, recent incoming data reinforce the view that we’ve reached the end of the rate hiking cycle.   
• A Fed pause and pivot will usher in the “clarity phase”, which in-turn will usher in in the ongoing price discovery phase. Volatility and uncertainty are not a friend of financial or debt markets. Clarity on the trajectory of rates will allow some of the dislocation to correct.  
• Rate cuts should not be misconstrued as the ultimate savior. Policy rates will ease allowing for the yield curve to eventually un-invert, yet policy and base interest rates are not going back to zero; they are going to normalize and settle-in higher than they have over the last decade.  
• Risk spreads also matter. Rate cuts certainly help from a clarity and base rate perspective, i.e. the greater the clarity on policy rates, generally the tighter the corporate- and other debt- spreads. Yet, risk spreads are also tied to macroeconomic conditions. If we are still facing highly uncertain or potential recessionary conditions, debt costs won’t necessarily tighten sharply right away because recessionary conditions typically result in periods of wider debt spreads. So the Fed’s rate cuts will help provide some clarity, but risk spreads will likely widen – at least initially, which means the CRE debt markets will still be expensive.  
• As the adjustment progresses, pent-up seller and buyer demand will fuel strong momentum on the other side. No doubt, higher costs of capital will require new borrowers to utilize strategic, innovative and creative approaches towards generating returns. The easy days of cheap debt and significant cap rate compression have passed, yet there is still value to be created and secular tailwinds to be harnessed. Eventually, sellers on the sidelines will either be forced to sell or eventually decide that the environment is clear enough to meet the market. Eventually lenders and buyers on the sidelines will also need to deploy record stockpiles of dry powder. In the meantime, buyers not as dependent on debt (such as HNW, family office and private capital) still have a unique window of opportunity to acquire institutional-quality assets while the rest of the market is quiet. 
• Diversification by Vintage Year Matters: a tale as old as time, 2024 will chronicle as one of the more accretive and attractive vintage years of this next cycle given the dislocation (lack of liquidity and triaging taking place) in the debt markets alongside the reset in comparative yield spreads that must occur.  

 Key Macro & Capital Markets Themes: 

• The “adjustment process” is in the early stages, and the CRE capital markets are in the process of feeling the full effects of normalizing (rising) interest rates.  
• An uncertain macroeconomic backdrop has weighed on forward-looking NOI growth assumptions. As the macro picture clears, and even as yield effects may remain negative (due to the adjustment process), cash flow effects can turn positive again, which will help to inflect appreciation returns.   
• Polarization from a cross-sector appreciation-returns-standpoint has narrowed over the last three quarters. 
• Looking ahead, property-level selection will play a more pronounced role in attribution as performance converges across sectors and managers (i.e. allocation effects grow relatively more measured amid narrowing Appreciation Returns).  
• This underscores the relative value that manager-expertise, track record and asset management will bring to portfolio management in the future. Allocation strategies of simply riding sectoral tailwinds will only be a piece of the puzzle in the next chapter.  

Diving Deeper: Institutional Portfolio Performance and Management in the Chapters Ahead  

Tracking institutional returns (and appreciation returns in particular) provides a distilled lens into the themes that will shape both this downcycle and the recovery ahead.  

The NCREIF NPI recently recorded its 5thconsecutive quarter of negative unlevered appreciation returns. Yet, there’s a lot more to unpack as to what it can tell us about performance looking ahead…. 

Chart 1 illustrates an important point on past polarization and recent convergence: notice that the Retail, Industrial and Apartment sectors' Appreciation Returns have converged more recently, while Office continues to pull back as an outlier. Prior polarization underscores the benefits of portfolio diversification, both from a downside protection and upside alpha-generation perspective. Yet, downturns tend to bring a convergence in performance, which is exactly what we’re witnessing right now.  

Chart 1

Taking a historic view of such polarization demonstrates just how significant and unique the last 3 years have been. At the height of this last cycle, we were seeing double-digit spreads between Appreciation Returns across sectors. The divergence in appreciation returns contributed to significant alpha-generation in the prior chapter for investment managers that were proportionally weighted to Industrial or Multifamily, for example, before the post-pandemic upswing in values unfolded.  

Importantly, polarization has narrowed over the last several quarters as the combination of ongoing macroeconomic uncertainty, together with the ongoing acceptance of the longer-term costs of capital, is causing a more broad-based pullback in Appreciation Returns and performance across even the most resilient of sectors.  

As higher costs of capital cause a broad-based rightsizing in yield effects, cross-sector divergence in Appreciation Returns is not likely to be nearly as pronounced as it was over the last 3 years. The more that the current uncertain environment collectively places pressure on NOI growth assumptions and key valuation metrics (going-in yields and exit-caps), the more convergence we will likely see in ODCE investment manager performance. Looking ahead, selection-effects (i.e. property level selection) are set to impact returns in a more pronounced way as allocation effects converge.   

Chart 2 illustrates that the composition of value changes has also shifted meaningfully over the last 2-3 quarters as investors have shifted forward-looking growth assumptions:  

Over the last six quarters, negative yield effects have pulled down appreciation returns (i.e. key valuation metrics such as rising cost of capital, rising discount rates, rising going-in caps and rising exit caps have impacted underwriting and valuation).  

Fortunately, cash flow effects (i.e. another component of appreciation returns that captures the net change in rent and NOI growth assumptions on a quarter over quarter basis) had helped to insulate some of the impact of yield effects on appreciation returns.   

More recently though, over the last 3 or so quarters, heightened macroeconomic uncertainty (and concerns of a more protracted period of economic weakness) has caused investors to moderate their forward-looking growth rate assumptions. While forward-looking NOI growth assumptions remain positive (for most sectors), they are not being upgraded on a quarter-over-quarter basis, so cash flow growth trajectories have come to a stand-still.  

So why does all of this matter? Cash flows (and expectations around future cash flows) are key to value creation and have fueled appreciation returns for the last several years. This was particularly true for the Industrial and Multifamily sectors, which witnessed double-digit rent growth. As those forward-assumptions ease, it has had a tangible impact on appreciation returns.  

This recognition is an important one as we think about the eventual recovery in this next chapter: even as the market adjusts to higher yields (i.e. negative yield effects persist), a clearer macroeconomic picture (which will continue to form throughout 2024) will help to reformulate an upswing in embedded NOI growth assumptions, which will help bring an eventual inflection in appreciation returns.  

OCTOBER 17 EDITION

QUICK BITES 

In this edition, we synthesize the interplay between interest rates, prevailing uncertainty and recent bond yields, while highlighting the important things to keep in mind for CRE Capital Markets. In our Deeper Dive section, we dissect the yield curve and describe why the longer end of the curve has shifted higher. 

• The most recent uptick in Treasuries acts as another force in tightening financial conditions and curtailing growth. At the same time, it’s given the Fed more ammunition to pause at their upcoming November meeting. 
• That said, inflation remains too high, and the Fed’s conviction on reigning it in remains firm. 
• We are seeing softening emerge in labor markets (wage growth is trending in the right direction), but September’s higher than expected CPI readings (particularly for Core Services) demonstrate that progress is going to be slower, choppier and harder-fought than it has been in getting from a peak of 9% y/y headline CPI to 3.7% y/y as of September 2023. Still, there were some encouraging signs out of CPI ex-shelter that point to further disinflation.
• Even as inflation comes in, the Fed will remain patient to ensure they see sustained progress. As a result, real yields will remain elevated, which will further curb growth for interest-rate sensitive areas of the economy (corporations, business investment, consumers, etc.), thus exerting additional pressure on the economy, eventually translating to job losses that will flow through to core inflation. This will prompt the Fed to consider rate cuts by mid-2024, paving the way for a renewed growth cycle in 2025. 

KEY THEMES THIS WEEK

• The 10-year Treasury yield “10YT” has spiked 43 bps over the last month [Chart 1]. To put that level of volatility in context, 2023 has experienced approximately 18 days where 10YT has shifted more than 2 standard deviations. This level of volatility even mirrors 2022, when the Fed had just started its hiking cycle, and comes close to the degree of volatility seen during the GFC, as well during the 1980’s when inflation prompted the then Fed to undertake aggressive hiking cycles. [Chart 2] 
  
• The volatility witnessed in the long-end of the yield curve acts as a further challenge to an already constrained CRE debt and capital markets environment because it adds to, and prolongs, uncertainty for lenders, investors and sellers.
  
• The volatility witnessed throughout longer-dated treasuries also sent the yield curve on a fluctuating journey. Yet, the yield curve remains inverted and points to impending recessionary conditions (tightened monetary policy takes time to flow through, and we’re facing a slow-burn credit cycle at the moment).
  
• While near- and medium-term fluctuations to the 10YT are underway, we recommend maintaining focus on the broader concept of interest rate normalization.
  • From a level standpoint, we need to get used to the 10YT being around 4% or higher. The decade leading up to the pandemic was not the norm, nor was it sustainable. Even when the Fed pivots, whenever that is, the long-end of the curve won’t come back down to abnormally low levels (think fed funds at 2.5%, and 10YT at around 4% or higher assuming a ~150 bps spread).  
  • CRE risk spreads relative to risk-free benchmark rates and corporate bond spreads must adjust upward. We are in the midst of that adjustment period now. A lack of adjustment would have important implications for allocations to CRE relative to other alternative investments. 
• Moving forward, two factors will drive the price discovery period and capital market revitalization. The first is stability in financial markets and interest rates, expected as macro policy and the economy stabilize. The second will likely be triggered by sellers facing liquidity needs, by those accepting to the new market "normal," or those dealing with conditions like impending loan maturity or property-specific weaknesses requiring additional capital. 
• As price discovery for necessity-based sell-side conditions prompt more activity, and as broader uncertainty fades (which it inevitably will), the market will reset and grow fluid. 
• We’re already seeing several institutional investment managers reaching out proactively to position themselves ahead of that full inflection point. 
• In the meantime, perspective is everything, and keeping a bigger-picture, yet simplified view of the complexities of the bond yields, of Treasury fluctuations and of the “higher-for-longer” misnomer is most important. Think normalization, not just a fleeting, finite period of “higher-for-longer” in forming your next investment strategies. 
  
   

DIVING DEEPER

Bond Curve Shifts and Cutting Through The Noise 

The yield curve is influenced by a variety of intermingling factors including; monetary policy, expectations of future interest rates, economic growth and inflation, investor sentiment (including both risk appetites and perceptions of risk), as well as just broader uncertainties surrounding things like supply (issuance) dynamics. 

Let’s Dissect the Yield Curve Across Term 

First off, the yield curve is still inverted, which happens to be a very reliable, historically accurate predictor of recession.   

The short end is predominantly influenced by Fed policy, which sets the overnight rate, which in turn acts as the basis for other shorter-term bond yields. Given that Fed policy remains restrictive (and that the Fed has yet to pivot), the short end of the curve remains high. Looking ahead, even as the Fed pivots, neutral fed funds is expected to settle-in at a higher level in the future as well.  

The long-end of the curve, meanwhile, is influenced less-so by monetary policy and more so by; future growth and inflation expectations, investor sentiments (risk perceptions and appetite), and uncertainty. The higher the future growth expectations, the more term premium required above short-term yields to compensate investors for holding for longer periods of time. Accordingly, the long end has shifted up dramatically, not only over the last year, but even more so over the last month as growth prospects and inflation expectations increased, thereby necessitating a rise in term premium.

Big Picture: Distinction on Higher-for-Longer HFL versus Normalization 

Those prior two bullets should help to redirect an often-misguided conception among the industry: even when the Fed eventually pivots, bringing-in the short-end, the long end of the curve will not necessarily return to abnormally low levels because both the short end of the curve will hold higher and because term premiums will have risen. 

If we take the Fed at the Fed’s word, and follow the dot-plot, the fed funds rate trends down to 2.5% through 2025 and 2026; and longer-dated treasuries such as the 10YT will need to maintain some spread. So, the distinction should not necessarily be higher-for-longer, but rather just higher (as in reverting to average). Rates will normalize higher across the curve. 

Why Has the Long End Seen So Much Volatility? What is Most Important to Understand?  

Rather than Fed monetary policy, the long end of the curve is influenced by interest rate and inflation expectations, risk (and term) premium, and broader investor preferences. With that recognition in mind, it should then come as no surprise that longer-dated yields have seen a lot more volatility lately because the aforementioned factors underlying their yields are more uncertain, fluid, and dynamic, respectively. 

• Starting with inflation and future interest rate expectations: the outlook for longer-term inflation has risen on the back of a broader soft-landing narrative. With better-than-expected incoming macroeconomic data, market participants have placed greater likelihood on a soft-landing scenario, which would mean that growth holds up and inflation remains within-target but trends generally higher than it has over recent history. Higher growth expectations translate to generally higher short-term interest rates and inflation expectations, in the most oversimplified of characterizations. Such higher expectations likely prolong this phase of uncertainty, preventing a clear narrative on inflation and interest rates from emerging.
• Next up, risk and term premium: interest rates (and therefore the underlying value of one’s bonds) can change dramatically over the course of a bond’s lifespan, particularly for longer-term bonds. As a result, a term premium is required for longer-dated bonds to ensure against the uncertainty of future yields and interest rate fluctuations. Term premiums tend to rise when there is significant uncertainty among forecasters and market participants surrounding future bond yields – conditions that we are most definitely facing today. Uncertainty has risen for a variety of factors, including uncertainty surrounding the impact of the $1.3 trillion new U.S. Treasury issuance through the end of the year (a supply-side shock so to speak)¹, uncertainty surrounding the Fed’s neutral rate and concerns surrounding mounting U.S. debt more broadly. 
• Finally, a catch-all bucket for things like flight-to-safety: in the wake of the Israel-Hamas war, we have seen many investors take a risk-off attitude, which has helped to bring the 10Y in about 10bps (as of October 16th). A risk-off approach is also adopted during recessionary conditions. While generally more cyclical and coincident with recessions, flight-to-safety can offset some of the other factors and drive yields down in the near-term). 

While near- and medium-term fluctuations to the 10YT may be occurring on the margin, most focus should remain on the broader concept of normalization. The adjustment to normalized, higher yields is underway, and underpins the basis of our forecasts. 

Stay tuned for updates to our House View forecasts, which will be released as part of our Macro Outlook in the coming months.

¹ Certainly, U.S. deficits and debt conditions were already known going into this period, which offsets a bit of the issuance uncertainty factor because the markets knew the U.S. would be issuing Treasuries. However, it appears that the market grew more uncertain about the impacts of issuance on the buy-side as foreign buyers and other domestic buyer pools (such as the Fed and U.S. banks) have offloaded Treasuries and stepped back as buyers (as QT for the former and liquidity issues for the latter have shifted their strategies). 

SEPTEMBER 19 EDITION

QUICK BITES 

In this edition, we talk about inflation (being too hot), the labor markets (showing early signs of weakness), and what this all means for the Fed. We also highlight a few key indicators we’re watching (quits rate and lending standards). 

• The Fed remains laser-focused on inflation’s link, sensitivity, and responsiveness to the labor market (underscored by their specific focus on super-core and core-inflation). 
• As a result, recession and softening in the labor market appear as increasingly necessary preconditions to the Fed growing confident in pivoting its monetary policy stance. 
• We don’t expect a pivot until at least late Q1 / early Q2 2024 at the earliest.  
• The consequences to the adjustment process (to tightened policy and higher interest rates) are more than likely to tip the economy into recession and set us up for a new growth cycle (aka recovery) sometime in 2025. 
• Collectively, the Fed’s restrictive monetary policy works to downshift credit growth, by design. 
• In some sense, the sooner this happens, the better, because it can provide the Fed the conviction it needs. 

KEY THEMES THIS WEEK 

• The Fed's actions may take up to two years to impact growth, but the sooner, the better. The CRE market seeks stability and clarity in financial markets. As macroeconomic conditions shift and respond, monetary policy, interest rates, and real yields will become clearer. This will lead to some tightening in spreads and spur some increased activity in debt and CRE capital markets. 
• We're further along in this process than it may seem, and there appears to be greater acceptance and focus on the medium- and longer-term horizons. Periods of dislocation offer often unparalleled circumstances of opportunity, points-of-entry, and thematic investment strategies, presenting an increasingly diverse spectrum of approaches and capital stacks. The path ahead requires an adjustment to the higher-for-longer era (pricing adjustments are still underway); on the lending- and buy-side, it also requires selectivity, expertise, and conviction. 
• Generating alpha in this next era will look different than it did in the era of dramatic cap rate compression and zero-bound interest rates. Yet, alpha is there for the taking and all those on the sidelines are sharpening their pencils to identify their next moves as the cycle progresses.  
• Alpha may be even more pronounced looking ahead, with even greater divergence among manager performance, a fact which underscores the importance of data-driven intelligence and the ability to discern structural and cyclical trends, leading indicators, and dislocations of relative value. 

DIVING DEEPER 

Steps in the Right Direction for Inflation, but Progress Remains Choppy

 
While August’s Headline CPI showed a notable increase due to higher gasoline prices (0.6% m/m to 3.7% y/y), Core Inflation remained steady at around 2.4% y/y on a 3-month annualized basis, aligning closely with the Fed's target. 
 
Most notably for the Fed, Super-Core Inflation, which excludes Housing Services and better reflects the costs of Other Services throughout the economy, accelerated 0.4% m/m, pushing the three-month annualized rate of growth back up to 2.2% y/y. Such an acceleration in Super-Core Inflation underscores the underlying tightness and resilience of the labor markets, particularly in areas like Airfare, Professional and Medical Services, Transportation Services, and Personal Services. It's worth noting that some sectors that ran hot this month are weighted differently in the Fed’s preferred measure of inflation (PCE), which may translate into a more palatable figure when that’s released in the next few weeks. 
 
The labor market has shown encouraging strides more recently, with a few months of easing wage growth metrics, all as Employment Diffusion Indices also downshifted materially, signaling that a larger swath of industries are easing their hiring. While the most recent moderation in hiring and the supply-driven rise in unemployment are helping to keep hopes of a soft landing alive for some, it’s important not to be fooled by coincident indicators.  

Monetary Policy Likely to Remain in Pause-Mode at September Meeting 

The Fed is likely to hold steady at the September meeting. Another rate hike in November is unlikely, but entirely possible (the market is pricing in a roughly 40% chance) because the Fed wants to see sustained disinflation progress. Fed Chair Powell's recent messaging at Jackson Hole was intentionally clear and specific to keep inflation expectations intact. The Fed remains laser-focused on inflation’s link, sensitivity, and responsiveness to the labor market (underscored by their focus on super-core and core inflation). 
 
As a result, recession and softening in the labor market appear as increasingly necessary preconditions to the Fed growing confident in pivoting its monetary policy stance. They'll be cautious even after reaching their inflation target, and any policy change isn't expected until Q1 / early Q2 2024 at the earliest.  
 
While the market is leaning towards a soft landing, we believe a recession is still on the horizon. Timing the call is challenging, but the economy is facing a tough adjustment to the higher-for-longer interest rate world. This adjustment is more than likely to tip the economy into recession, setting the stage for a new growth cycle around 2025. 

What We’re Watching  

We're closely watching labor market indicators like Employment Diffusion Indices, Quits Rates, and Employment Confidence Measures. 
 
The consistently falling quits rate indicates employees are less inclined to change jobs, which could help moderate wage growth because Job Switchers have captured more wage gains over the last few years.

Interest rate-sensitive sectors are beginning to feel the effects of rate hikes. CRE felt the brunt first, yet, the impact of rising interest payments and tightened credit will gradually extend to both consumers and corporations; oncoming corporate debt maturities will also limit growth and investment for the latter (which also indirectly affects the former). 
 
The Fed's tight monetary policy is intentionally designed to influence growth in this manner. Yet, the Fed’s hiking cycles typically take up to two years to influence growth, both in the form of higher debt costs and broader credit tightening (chart below). The sooner the response and contraction in growth, the better, because it can provide the Fed the conviction it needs. 

AUGUST 24 EDITION  

Hot Topics: Let’s Talk About Interest Rates, Monetary Policy, Inflation & Jackson Hole

If you read the news at all, you’ve probably seen all sorts of headlines around monetary policy, inflation targets, and “R-Star”, or neutral real interest rates. If you weren’t already dizzy, you sure are now. But how do we make sense of it all? And what does all this really mean for CRE, and for our macroeconomic outlook overall? Moreover, how on earth can we establish a near-term outlook if people are saying that all of these thresholds and targets should change??

First off, let’s decompose a few of these topics and then link them back together to establish a baseline view for what the future may resemble.

What Is R-Star? How Is It Utilized to Judge or Gauge Monetary Policy

R-Star is an inferred number: it is effectively the real short term Federal Funds rate that allows for economic growth to prevail at a pace that is consistent with their inflation target.1 Considered a “neutral rate,” it is neither expansionary, accommodative, or contractionary.

R-Star reflects the interplay between real economic growth, inflation and monetary policy, and it is inferred against the context of a quantitative model. More importantly, R-Star is not a static theoretical number over time (it’s a fluid theoretical one!...oofta!); it can rise or fall based on the underlying structural composition and behavior of the economy; it can theoretically change because the composition of the economy is always changing. The structure of labor force, demographics, scale of excess savings, pace of innovation, business investment, fiscal conditions, infrastructure and productivity are all fluid dynamics that evolve and change over time. Therefore, any conversation on the longer-term R-Star (or neutral rate) requires an awareness of the economic factors that affect R-Star.

If prevailing monetary policy (in the form of the real Federal Funds rate) is higher than this “neutral rate of interest,” then monetary policy is considered restrictive (and vice versa).

Why are we talking about it? People debate what R-Star is and what it should be because they want to determine whether and when monetary policy is “just right” or whether (in this case) it is too restrictive. They compare it to the applied, real-world equivalent of the short-term nominal rate of interest adjusted for projected or future inflation.

R-Star is brought up in conversation (throughout the media, etc.) to contextualize the outlook on where real and nominal base rates will trend over the medium- and longer-term time horizon, which helps participants form an outlook for their investment strategies.

In this very oversimplified context:

Nominal Fed Funds = R-Star (aka the theoretical real, neutral rate) + the target inflation rate.

By utilizing R-Star as a reference point, market participants can look to prevailing monetary policy and say something along the lines of: “yes, we agree that prevailing monetary policy is too accommodative (if inflation is rising above desired pace, for example), so monetary policy still needs to be more restrictive in order to get us to the neutral, real FF rate.” Conversely, and at different times in history, market participants could also say, “we agree that prevailing monetary policy is too restrictive (given that inflation is falling or that inflation has reached its target), and nominal FF should decline in order to align with the neutral rate.”

¹ The Fed has two mandates, stable prices and full or maximum employment. They utilize the Federal Funds Rate (which is a short term interest rate) to manipulate the economy and track where real rates, inflation and growth are trending to evaluate whether their monetary policy interventions are effective.

Why the Conversation Around R-Star Now? And What Is the Real Rate Anyhow?

If you read the news at all, you’ve probably seen all sorts of headlines around monetary policy, inflation targets, and “R-Star”, or neutral real interest rates. If you weren’t already dizzy, you sure are now. But how do we make sense of it all? And what does all this really mean for CRE, and for our macroeconomic outlook overall? Moreover, how on earth can we establish a near-term outlook if people are saying that all of these thresholds and targets should change??

Up until recently, conversations around R-Star weren’t as prevalent in mainstream media because the market was widely in agreement that monetary policy rates were still below the neutral rate: it was very clear that inflation was trending too high (just a year ago headline CPI was at 9% y/y), and it was very clear that the real rates needed to rise in order to bring more balance to the economy in order to reign-in inflation to the Fed’s 2% target. Everyone understood that rates needed to increase to reach the neutral rate. But now, after 500 bps of cumulative rate hikes, the economy is still chugging along, and inflation has taken steps in the right direction.

So, the questions around 1) where real rates are, and 2) we are relative to the neutral rate, has grown more prevalent now, not only because of the scale of rate increases, but also because many contend that this scale of rate increases will be sufficient to bring us back to an acceptable inflation level such that we can work on getting back to that happy-medium point (aka neutral point) and the Fed should work on returning to neutral before growing too restrictive (past the neutral monetary policy point).

Many chose to judge the degree of monetary policy tightness by comparing the short term, inflation-adjusted actualized rate to R-Star. If real rates are trending above R-Star, it signals to analysts that policy is potentially too restrictive. If actual, real rates are trending below R-Star, if could signal that additional tightening is necessary. Notice that real short-term rates were trending below zero for the better part of the last 20 years following the GFC when monetary policy turned very accommodative. Prior to the GFC, real rates hovered near 2%. The Fed’s more recent tightening cycle has pushed real rates upwards to 1.5%.

So what is R-Star (or the ideal, neutral rate) right now? Given that it is not a directly measurable rate, it is sometimes inferred from the Fed’s prevailing Summary of Economic Predictions (SEP) Report released every quarter.

According to the June 2023 SEP, Fed officials still indicate that the nominal, Long-Run Fed Funds rate is expected to trend back to a 2.5% neutral rate²; stripping out the inflation target³ of 2% arrives at an implied 0.5% R-Star rate.

Many folks in the news, then, are taking the real rate (of around 1.5% above) and claiming that it is high relative to R-Star, implying rates will come down.

Yet, gauging R-Star is not quite that simple, which is why market participants look to quantitative models, as well as to Fed Officials to signal how they are viewing R-Star. Both the New York Fed and the Dallas Fed have released papers on gauging R-Star.

The New York Fed has two different models that aim to measure R-Star, the Laubach-Williams Model and the Holston-Laubach-Williams model; and the results of both are pretty far apart. The former (LW) model estimates that longer-run neutral rates should be around 1.14%, while the latter (HLW) model estimates that long-run neutral rates should be 0.58%. Meanwhile, an economist at the Dallas Fed compiled a model that indicates long-run R-Star should be around 0.7%.

Regardless of which metric used (and rest assured the Fed is evaluating each), these models confirm that prevailing real rates (of 1.5%) are likely near their peak. Real rates, however, are likely to remain higher for longer and eventually trend lower as the hiking cycle unwinds, though they are not going to return to a zero bound.

If you read the news at all, you’ve probably seen all sorts of headlines around monetary policy, inflation targets, and “R-Star”, or neutral real interest rates. If you weren’t already dizzy, you sure are now. But how do we make sense of it all? And what does all this really mean for CRE, and for our macroeconomic outlook overall? Moreover, how on earth can we establish a near-term outlook if people are saying that all of these thresholds and targets should change??

² We are currently at a nominal Fed Feds rate of 5.25%-5.5%, and the rate cutting cycle is going to take time to reach the long-run neutral rate that the Fed references here.
³ Until the Fed and/or Chairman Powell signal otherwise, the 2% inflation target should be considered what they will be managing towards.

There Are Still Two Parts to the Equation for Nominal Federal Funds Rate: R-Star and Target-Inflation

If you’re listening to the news, and you hear a reporter ask someone directly, “where is R-Star” or “Is the Fed going to talk about changing the inflation target at the Jackson Hole Summit,” they are essentially asking the guest where they believe long-run real rates will settle once the inflation threshold is taken into account. Two different questions, with an interrelated answer.

To oversimplify, sure, R-Star could in theory be held constant, yet Nominal Federal Funds could change if Federal Reserve policy makers determine that the threshold for acceptable inflation should change. Many industry pundits (such as this WSJ article) are now contending that the Fed’s inflation target should be higher than it once was and is, (for example, that it should increase to 3%, rather than 2% because of structural factors in the economy that will change long-run inflation trends well into the future), all of which has implications for R-Star and implicit monetary policy stance.

In addition to debates surrounding whether the inflation target should change, debates have emerged as to whether R-Star should change (and shift higher to accommodate changes in the economy.

These questions are interrelated and get to the same underlying point – which is, “has the composition and makings of the economy changed such that higher inflation and a higher real rate of interest is acceptable?”

Do the Debates On R-Star and Target Inflation Matter?

In one sense: these debates help to provide a way to think about whether the Fed’s monetary policy and its targets or thresholds are effective for the modern-era economy. The results of such assumptions impact opinions around what the longer-term outlook is for benchmark interest rates and for the direction of the economy more broadly.

Yet, in another sense: the debates add a lot of noise to your already noisy days; because these are, indeed, still debates about “equilibrium rates,” invisible targets and thresholds, and philosophies that very few of us (other than the Fed official) have intel into. It’s very difficult to measure real rates, it’s even more difficult to derive R-Star. So, keep the language in the toolbox, but keep a view on Fed messaging rather than on endless pontification throughout the media.

We also must not forget that the Fed has held these target rates, ideal thresholds, and invisible barometers for the better part of the last two decades without actually holding or achieving these conditions for a consistent period of time. If achieved, the moments have surely been fleeting. Lest we forget, there are also all sorts of ‘black swan’ events and unexpected wrenches thrown into the proverbial equation that abruptly interrupt the Fed’s careful interventions. And, in the case of the pandemic, many have argued that certain segments of the economy have structurally shifted, which brings us back to the arguments behind shifting such long-held thresholds.

What Should We Be Watching and What Should We Expect from The Fed’s Meeting In Jackson Hole?

We continue to closely monitor the messaging sent from the Fed, and often report highlights to our clients on reading between the tea leaves of the Fed’s post-meeting minutes and Fed policy statements.

We’ll closely follow messaging from Fed Officials as they meet at the Jackson Hole Economic Symposium. Fed Chair Powell’s report will be intently evaluated (and likely all over the news), though he is unlikely to shift from the playbook too much. The Fed wants to keep the markets reassured and focused on the fact that they are committed to tempering inflation to its current target of 2%; they want to ensure inflation expectations remain anchored. If they signal that they are considering changing the inflation target right now, it could further upend financial markets and send additional waves of added volatility through the markets as they potentially reprice to higher longer-term inflation.

Should We Be Watching Inflation Expectations?

Speaking of inflation expectations, market-based inflation expectation measures (that compare nominal Treasury Yields to inflation-adjusted TIPS yields)⁴ have ticked up over the last month or so, largely as the consensus narrative has shifted from one of impending recession to soft landing. As the prospects for recession have been downgraded by some (though, not us), more growth and inflation is being priced in to the financial markets given that they have shifted towards a recovery narrative.

Importantly, the Fed monitors these inflation expectations (held by both the financial markets and by households’), and they view any upward shift (above target) as further justification towards keeping policy restrictive enough to bring expectations back in-line with their target. This reality is worth keeping in mind during any R-Star conversations that claim the Fed is going to be motivated to cut rates simply because of where may be relative to R-Star. They will not be impatient; they do not want a repeat of the 1970’s and then way to ensure that 1) inflation consistently trends towards target for a sustained period of time and 2) that inflation expectations remain anchored.

⁴ Market-based inflation expectations utilize treasury yields to estimate markets’ expectations for inflation. For example, the 10Y Treasury Breakeven rate compares the difference in yields between Nominal 10Y Treasuries with yields for Treasury Inflation Protected Securities (TIPS) that are tied to changes in the CPI. The breakeven point reflects the real rate at which the two types of securities would yield comparative returns.

What Is Our House View on Where Interest Rates Will Settle?

We formulate our baseline outlook by taking the Fed at the Fed’s word. In doing so, the SEP continues to call for neutral long-run nominal Fed Funds to eventually return to 2.5%. This is a departure from the near zero-bound range that FF trended at for the last decade, and the market is gradually accepting that interest rates are going to not only be higher for longer (to tempter inflation), but also that they will settle-in at a higher neutral rate.

We can debate what these target thresholds (should be) until we’re blue in the face, and we can postulate as to what inflation target the Fed will or will not change to, but ultimately – it is the Fed that decides. And Fed decides against the context of a fluid economy and financial market. So, it is best to understand historic trends and relationships in formulating views for what could happen in the future.

Our baseline assumes the Fed is done raising rates at this point, at a terminal rate of 5.25-5.5%. Consistent with the messaging inferred from R-Star discussion, prevailing monetary policy is well above the neutral rate. The rate hikes are working to slow the economy, and inflation is coming in (albeit gradually from here given sticky elements challenging the Fed’s job from here).

By the end of 2023, inflation will remain around 3%-3.5%, all as further recessionary conditions will set-in  (given a confluence factors, including the cumulative impact of tightened credit conditions on business conditions and growth, a cooling labor market, and a potential government shutdown in October). On the back of such contractionary macroeconomic conditions, the Fed is expected pivot in late Q1 or early Q2 2024 and gradually start cutting rates from there.

With gradual and patient rate cuts, the Fed funds rate should trend down to the neutral nominal rate of 2.5% by 2025-2026. The 10Y treasury, meanwhile, will trend approximately 150 bps above the nominal neutral rate, which reflects a spread that aligns with the long-run historic average. A 10Y treasury of 4% is also consistent with 2% inflation and 2% real GDP growth. For more insight into these bigger-picture trends, check out our Glide Path Report.

AUGUST 2 EDITION  

Bringing It All Together

Following up on some of the themes we have discussed in the U.S Capital Markets Glide Path Report and Behind the Numbers video series, we’ve seen positive progress on several fronts: inflation is trending in the right direction, wage growth is easing, the Fed appears to be nearing the end of its rate hiking cycle. Moreover, some of the distinct volatility felt at the onset of the rate hiking cycle has dissipated, all as market conditions have also calmed down since the immediate wake of the SVB banking crisis.

Yet, the Fed, the financial markets, and yields for risk-on asset segments, are all highly sensitive to incoming macroeconomic data releases. In fact, the Fed reiterated they remain patient, data-dependent, and focused on seeing durable (i.e. consistent) progress made on inflation. Therefore, much of the outlook hinges on the tightness of the labor markets, and on elements of inflation that are tough to wrangle – progress might not be as easily won as it has thus far (given base effects, cooling energy prices and easing supply-chain influences).

The macroeconomic backdrop may feel overwhelming, with all sorts of occasionally contradictory indicators coming in daily. So, the picture bigger remains key – measures of core inflation must come in. As that occurs, the Fed cause pause, and then pivot, allowing financial markets to settle and providing some more clarity on the path of macroeconomic growth. In the meantime, debt markets remain challenged with tight liquidity and stringent credit standards resting upon relatively more uncertain macro-outlooks.

Ultimately, the mood heading into 2H 2023 is one of cautious, selective, and necessarily patient optimism, founded on the premise that we are nearing peak Fed Funds. As that key milestone is reached (even if it is against the context of slower or recessionary conditions), it will usher in a period of greater clarity, financial market stabilization and some tightening in spreads.

For the moment, though, we are still in the early (almost stubborn) periods of price discovery, a process which will unfold throughout the remainder of this year and well into 2024 as the industry collectively adjusts to a higher-for-longer interest rate environment.

Whether its denial, or confirmation bias, it’s a reality that cannot be outrun, and a reality that implies value adjustments are nevertheless required, particularly in necessity-based sell side circumstances prompted by loan maturity, redemption/liquidity needs, and/or related to floating-rate/bridge loan debt structures.

Undeniably, it’s a frustrating, painful, and choppy process that takes time to unfold, not only because it involves gradual changes in buyer, seller, and lender psychology, but also because it involves tough case-by-case decisions made on assets with varied and complex capital stack structures and operational conditions. The process will inevitably happen though, which requires (and will likely reward those who are) facing these shifting conditions head-on and making those tough, informed decisions. And, for many on the buy-side, it also offers a unique moment in time and window of opportunity heading into the next cycle.