Although the graph above looks like an old Atari game, it is the Federal reserve dot plot which shows a profound shift. Ironically, just a few weeks ago the Federal Reserve was touting higher rates for longer. Now the federal reserve has done a 180 and has penciled in three rate cuts for next year. Why the reversal? The market went nuts after the announcement with the Dow reaching new highs while interest rates dropped. What does this announcement mean for real estate? Are the projected cuts good news? On the flip side, my servicing data is painting a starkly different picture.
Why did the federal reserve reverse course
I was quite surprised at the tone in the recent meeting as just a few weeks prior the Federal reserve was steadfast in higher for longer rates. At the same time inflation data is falling, but there is still considerable uncertainty as to how or when it gets to the 2% target. Furthermore the economy continues running hot with retail sales topping expectations. With all the good news it was quite surprising for the federal reserve to announce cuts. If anything I would have anticipated the opposite with the federal reserve emphasizing more hikes.
It is a mystery as to why the announcement of cuts in the face of steady inflation and a humming economy. Here are three opposing theories:
- Federal Reserve bowed to political pressure: It is no secret that Americans overwhelmingly think the economy is bad, the federal reserve can easily help by lowering rates which will lower rates on mortgages, credit cards, etc.. and swiftly increase the perception of the economy. Whether this is true or not as the motivation remains to be seen, but has been talked about in both Democratic and Republican leaning publications.
- Inflation is anticipated to fall considerably faster: The federal reserve might think that inflation will magically fall quicker than the current numbers. I think this is highly unlikely, but they might be more optimistic than the numbers are alluding to
- They are scared of a worse outcome: As the markets rejoice that a soft landing is imminent, the projections by the fed could be too get ahead of the bad news coming so the good news on rates is ironically bad news on the economy. Furthermore they switched their focus too early to jobs as opposed to inflation (more on this below).
Federal Reserve dual mandate creates a problem
I wanted to highlight an issue with the federal reserve which is going to create problems now and into the future. Historically the only mandate of the federal reserve was price stability. In the last 10 years or so the mandate has changed to include full employment. Unfortunately the federal reserve is now focused more on full employment and the effects of interest rates as opposed to price stability. This is creating a huge conflict as today, the only wat to get inflation reduced is if the labor market cools off, but without the labor market cooling off we cannot have price stability or long term employment gains. This dichotomy will increase the risk in the economy.
My data as a lender showing distress ahead
Even though the markets are over the moon about the future cuts and have thrown caution to the wind my data is showing interesting times ahead. As a private lender, we hold and service all of our loans. We have been tracking various metrics in our portfolio for the last 25 years and two metrics are jumping out that point to interesting times ahead:
- Payoffs down 200%: This is an interesting metric, as a private lender the goal of our clients is to use us as a bridge to more conventional financing. This is not occurring as there are substantial liquidity constraints. Small and mid size banks, the backbone of lending, are substantially pulling back. Furthermore, lending standards across the board have tightened substantially leading to considerably less payoffs. This is a red flag for the economy as growth cannot continue without liquidity/financing. On a similar note, we are fortunate that we hold our loans in cash so we are not experiencing liquidity issues like many others.
- Call volume up 30%, closing volume about flat: Although our call volume is up substantially, our close volume is about flat. The reason for the discrepancy is that more borrowers are in distress without enough equity. We are seeing this most profoundly on the commercial side as we are very far apart on values for apartments, office, etc.. with higher cap rates.
Interest rates will stay in the 6-7% range
The federal reserve is predicting 3 quarter point cuts which would put rates between 6.5% to 7.5% as the market has already factored in the future cuts. I would be surprised to see rates fall much beyond this range even with the announced cuts.
Even with rate cuts, substantial downside risk
The market is rejoicing rate cuts and factoring in a 100% chance of a soft landing. Unfortunately this optimism should be tempered. My servicing data is showing a huge liquidity crunch coming down the pipe that will have profound impacts on the economy. Without financing/liquidity there likely will be a train wreck in the economy especially in regard to commercial real estate.
Bill Dudley, prior head of the NY federal reserve bank, summed it up nicely: “the central bank’s dovishness also increases the possibility of no landing at all — that is, overheating and persistent inflation that could undermine the Fed’s credibility, while requiring renewed tightening and a deeper recession to get things back under control.”
Summary:
The market is misguided in pushing up risk assets like stocks with huge downside risks everywhere. Even with the upcoming cuts by the federal reserve, there will still be liquidity crunch as rates will fall by about ¾% max. This is likely already factored into long-term rates. My servicing data backs this up with a huge liquidity crunch arriving next year, especially in commercial real estate. This crunch will not be resolved with small cuts by the federal reserve.
Furthermore, commercial real estate is in for a substantial correction as long term debt must eventually be repaid at much higher rates. On the flip side, consumers are facing a debt fueled binge that also must be reckoned with. I would advise not to buy the market hype of cuts as the downside risk is considerable.
Additional Reading/Resources:
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine, The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
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