Live in Hope…Die in Despair! Will Interest Rates Come Down (Far Enough) This Year?

I sure hope they will. While I’m a member in good standing of the higher-for-longer club, I would love to be convinced that rates are coming down…a lot. I want to believe all those eminent and eminent-adjacent talking heads making convincing arguments that interest rates are going to come down fast and hard. The derivatives market seems to be on board. Forward-market pricing implies 6-7 downward adjustments of the Fed funds rate this year taking Fed funds from the low 5s into the upper 3s. (Of course, when is the last time that market got it right?)

But the Fed heads are seemingly not fully on board. As some wag said not that long ago (I am unburdened by charges of plagiarism, having withdrawn my application for the presidency of Harvard) perhaps, we should stop reading between the lines and actually read the lines. The Fed’s been consistently messaging “not so fast” as Coach Corso might say. 

The question for the real estate capital markets is, of course, not will they come down, but will they come down far enough and fast enough to reliquefy our market? Certainly, even a couple of 25 bps reductions will help and perhaps create a sense of momentum which, while it might not be permanent, would be an enjoyable sugar high as everyone decides to get all their deals languishing on the shelf done at once. But in order to put paid to the latent and abeyant risk (certainty?) that the legacy book will surely experience a difficult period of repricing,  the curve would need to shift down an awful lot…and quickly. 

Many of my colleagues who actually make their living in debt capital markets, seem very much of two minds about the course of interest rates during the current year. The December survey results from the CREFC Board of Governors was pretty sunny but conversations among that same group of people at the CREFC in early January were considerably less so. Folks aren’t lacking in acumen…the data isn’t just terribly coherent. 

There are easy arguments for Fed funds to come down dramatically this year. While one could quibble about which dataset regarding inflation one looks at, on balance, inflation is definitely on a downward trend. (But note for those, like me, who are mathematically challenged, a 3% inflation rate is still 50% above the 2% target.) From a blackboard perspective, if inflation is 2%-ish, a 5% nominal Fed funds rate would be quite restrictive. 

While unemployment is certainly not a problem now, there’s a reasonable concern that employment levels may begin to shudder and that would be a strong argument for the Fed to get increasingly accommodative. If we’re worried, perhaps it’s best to at least be less restrictive right now? 

And there is the lingering worry that we are we missing some of the tells that the economy really is not that robust. The glow on the cheek is fever and not ruddy health? Is it possible that a recession remains around the corner? As most of the fiscal stimulus from the past several years is now burning off; we might find out what happens, as Mr. Buffet famously said, “When the tide goes out.” Similarly,  while the consumer appears to be undaunted by pretty much everything (the December buying season was pretty damn good) the consumer sector, at any moment, might all of a sudden become aware of its burgeoning credit card debt and turn on the proverbial dime. 

With all that said, it’s fair to say that a recession is not entirely off the table within the year to 18 months, and under those circumstances perhaps a soupcon of Fed funds relief would be a good thing…a little insurance? Yet the economy is doing pretty damn well. How annoying for the doves! GDP is holding up. Fourth quarter GDP was about 2.4% and 2023 is likely to come in closer to 3%. That is, by historical standards, vigorous. There also seems to be a consensus on the Street that something in that 2.3-2.4 range is likely for the full year of 2024. Unemployment is not right now a problem. Wages are holding up. The long-predicted recession continues to drift into the gauzy distance. 

So, what do we make of all that? Will we get material interest rate relief? Should we get material interest rate relief? Will Fed funds come in? Will SOFR retrace and carry with it the ten-year? Will QT stop? Reverse? 

Bottom line, market interest rates are almost certain to come in materially (note the “almost” part of that) this year. Not only does that make (some) sense, it also reflects the consensus. When committing to a plan, however, it behooves us to ask are there things out there that might still spoil the party? There are. 

First, of course, the economy is doing just fine. The Fed doesn’t typically cut rates in that environment. I think it happened once. If GDP holds up as expected in 2024, it would be, from a certain perspective, rather odd for Fed funds to come in materially. 

Let’s talk legacy. 

Mr. Powell clearly has a picture of Paul Volcker taped to his bathroom mirror at home, having surely consigned portraits of Arthur Burns and William Miller to a dark corner of his basement. He’s a smart man (he is a lawyer after all). He is undoubtedly aware that Messrs. Burns and Miller have largely faded from collective memory, except for residual sense that their leadership might be best forgotten. Mr. Volcker is still resplendently present with us with his reputation intact. He may have destroyed the economy for a bit, but he did defeat inflation. There’s a lesson here. Protect the economy in the short term and use interest rate policy to support growth and be tossed on the midden heap of history. Bring it all down and fix inflation and be a star. Hmm. Legacy suggests the current Fed is more inclined to Volcker-ize us than not. 

How about politics? Like most of us, I  am saddened that we’re already in the election year tumult and let’s be clear, Fed policy impacts political realities and political realities affects Fed policy. I know, I know. Independence is sacrosanct, but everyone understands the realities. If they cut near to the election, they’re beholden to the White House. If they don’t, they’ve been MAGNA-tized. Not very comforting. If they’re going to do something, they better move early and right now the data constitutes less than a compelling argument for any big moves. If the Fed moves late, they’ll struggle to avoid the Charybdis and Scylla of politics. 

Finally, there’s just good old housekeeping. Policymakers have to be extremely mindful as to what they might need to do if the economy truly suffers a significant recession (and at some point, it of course will). Since one of the Fed’s primary functions is to ride in on the white horse when things go casters up and provide liquidity, would the Fed rather enter the next economic crisis with Fed funds at 3 or even lower, or would they rather encounter those sorts of existential problems with Fed funds a couple of hundred points higher? The answer is obvious: dry powder is the ultimate balm for Fed policymakers. 

So, the economy doesn’t suck. Politics makes any dramatic change this year challenging at the least. Legacy anxiety suggests that there is asymmetrical risk between accommodating too early and fighting inflation. Policymakers have to be mindful of the efficacy of the tools in their toolbox in the years to come. 

Could someone on the Fed develop an “if it ain’t broke, don’t fix it” cast of mind? Might some members become bewitched by the notion that our current rate anxiety is largely attributable to having marinated in the zero bound for over a decade and is somewhat illusory? There was a day, not that long ago, when a healthy economy looked like 2-4-6. 2% inflation; 2% real Fed funds (4%); 2% for duration (6%) and a cap rate making all that accretive. If the economy is functioning well, one might make the observation that it might be less than prudent to pour accelerant onto an already moderately hot economy (ok, not hot, but warm)? 

Look, I’m not gainsaying the experts here. Even the Fed heads are saying that Fed funds are coming in this year. All I’m saying is that there are circumstances out there that may suppress the speed and scale of any Fed funds retrenchment. Even a whiff of inflation, a whiff of excess exuberance may turn the Fed eyes back to these other issues embolden it to resist the drumbeat of pressure to cut fast and deep. 

Remember, when I’m engaging in this “on the one hand vs the other hand” dialectic, I’m doing it through the lens of the CRE finance marketplace. Surely, none of us would be offended by the possibility of a bit of a sugar high over the next 2 or 3 quarters. Some deals would get done, but 100 or even 200 bps downdraft in the curve, while perhaps good for the economy writ large and certainly for the consumer, doesn’t look like it would be enough to fix the problem confronting us in the commercial real estate finance marketplace. The legacy book is still enormous. We’ve got a trillion dollars of debt or more to be refinanced within the next year and a half. Most of that was closed when Fed funds was near zero and the ten-year hadn’t been far in excess of 2%.

Where that leaves me is with annoying concern that our legacy problem will continue to be painful and that nothing the Fed can do in any reasonable range of policy bromides will fix it. We’re not going back to the zero bound (or at least most of us hope not). That means billions of dollars of assets will need to be repriced. That’s true of SOFRs at 5.4%, that’s true of SOFRs at 4.2%; that’s even true of SOFRs at 3% (which very few think it will see anytime soon). What may salve many wounds to the body economic might actually not do all that much for the CRE market. We will, of course, repair, but that repair is going to continue to involve a painful repricing. 

But then again, maybe I’m wrong. I’m okay being wrong here.