What Might Balance Sheet Normalization Mean for Investors?

After a series of rate hikes to start 2017, the Federal Reserve paused the process of interest rate normalization—but it announced its plans to begin normalizing its balance sheet.
Al Brooks, Head of Commercial Real Estate
September 21, 2017

Following its September meeting, the Federal Open Market Committee (FOMC) announced that it will leave the Federal funds target range unchanged at 1 to 1.25 percent. As widely expected, the FOMC did, however, announce its plans to begin reducing its balance sheet in October. Bond markets will be watching closely as the Fed begins to unwind its excess holdings left over from the era of quantitative easing.

Balance sheet reduction has the potential to raise Treasury yields, which would push up long-term borrowing costs for the commercial real estate market. But the Fed’s actions should be gradual, and fixed rates will likely remain at historically attractive levels.

State of the Economy

The Fed’s decision to normalize its balance sheet should be viewed as a sign of the overall health of the economy. Despite inflation still falling below its 2 percent target at the moment, the Fed’s commentary on the state of the economy was positive, with a strong labor market and stronger-than-expected GDP growth in Q2 supporting its view.

The Fed highlighted the impact of the recent hurricanes on the economy, stating, “Hurricanes Harvey, Irma, and Maria have devastated many communities, inflicting severe hardship. Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term.”

Notably, it addressed that the effect of the hurricanes might elevate gas prices, causing a temporary uptick in inflation in the very near term. However, that uptick will eventually be followed by a move closer to the Fed’s target: “Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term,” it stated.

Balance Sheet Normalization

During the worst of the recession, the Fed purchased Treasuries and mortgage-backed securities in an attempt to spur private sector investment and to keep medium- and long-term rates low. With the Fed willing to buy large volumes of Treasuries at extremely low yields, profit-seeking investors were incentivized to move funds into corporate bonds and other assets. The quantitative easing program was successful in promoting growth, but it has pushed long-term bond yields—and interest rates—well below their true equilibrium level. As the Fed exits the market, private investors will fill the void, and they will likely demand a rate of return that does more than cover inflation. Rather than securities sales, the Fed plans to reduce its balance sheet by opting not to reinvest security proceeds in levels that will grow gradually over time. The Fed’s approach should reduce any sharp impact on interest rates.

Checking the Record

In the past, the Fed has been reluctant to raise rates when inflation has been running below its official 2 percent target over the long term. The last sustained series of interest rate hikes came between February 2004 and June 2006.

Over the course of 30 months, the Fed voted to hike rates 17 times, lifting short-term interest rates from 1.25 percent to 5.25 percent. 1

Notably, the chained personal consumption expenditures (PCE) measure of core inflation remained slightly above the Fed’s 2 percent target for almost the entire duration of the tightening cycle.

Last winter, the economy appeared ready to support another prolonged rise in interest rates. Job growth was outstripping the underlying expansion of the workforce, leading to rapid tightening in the labor market. Inflationary pressure had started to build, with chained PCE rising 1.9 percent YoY in October. But after three rate hikes, inflation fell back to 1.4 percent1, and no additional action was required to control rising prices.

Inflation’s weakness has come as a surprise to many—the labor market has continued to tighten, equities markets are setting new records, layoffs are at historic lows and a variety of other economic indicators all confirm that the peak of the business cycle is approaching. The Fed may have paused hiking rates, but the economy is giving it no reason to reverse course.

J.P. Morgan Markets Interest Rate Forecast

Hover over sections of the graph to show additional information. Click on a category to show or hide its data.

 

Source: J.P. Morgan Markets; as of September 15, 2017

Keeping the Climb in Context

Treasury yields are widely regarded as a key benchmark for all fixed interest rates, so rising yields will naturally push borrowing costs higher for a broad range of corporate and personal debt. But even if balance sheet normalization allows long-term interest rates to rise, borrowing should remain cheap by historic standards.

So long as the economy continues to grow and create jobs, a modest rise in interest rates should not drive a negative reaction in commercial real estate. In fact, a stronger job market and increased consumer spending should positively affect investors.

If inflation returns, the FOMC is expected to resume raising short-term rates with a hike in December, bringing the target range to 1.25 to 1.5 percent. As rates lift off, investors should consider building a larger cushion into their plans, allowing for a future when borrowing is slightly more expensive. It’s important to note that throughout the current hiking cycle, the Fed has been very cautious—only raising rates when it’s confident the economy is strong enough to withstand it.

And any burden caused by higher interest rates should be more than offset by an improving economic landscape. Expanding businesses and a rising tide of consumer spending promise to drive demand for commercial real estate.

1The Federal Reserve

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