Why we may enter a period of halting rates

August 02, 2018 11:05
With inflation well under control, the US Federal Reserve has ample room for a slower rate increase pace. Photo: Reuters

As real-estate analysts and investors, we track developments in the interest rate regimes. We note that, in many conversations, investors are concerned of the impact of higher interest rates to the REIT markets. However, several recent developments suggest that the pace at which interest rates rise may not be as quick as the market had originally expected. In fact, we may enter a period of halting rates over the next 12 months.

First, recent comments from the President Donald Trump suggest that the US government prefers a more dovish stance from the Federal Reserve. While the Federal Reserve is independent of the US government, recent geopolitical developments, most notably the trade disputes with China, incrementally weaken the economic outlook. With inflation well under control, the Fed has ample room for a slower rate increase pace. In fact, after Trump’s comments, the US Dollar weakened, suggesting that the market is taking the president’s comments seriously.

Second, recent developments in Britain suggest that Brexit may ultimately be more disruptive than what the Theresa May government had suggested so far. Prominent pro-Brexit cabinet ministers, including the now ex-foreign secretary Boris Johnson, have resigned from the government over the official government position of a soft Brexit. This position suggests Britain should continue to adopt the EU common rulebook on goods trade, which will largely maintain an open goods markets between Britain and the EU.

In the next several months, the British government will need to negotiate the final Brexit terms with the European Union, and then it will need to bring the agreed package to a vote in the parliament. Both steps can still prove to be difficult, especially since the Conservatives do not have an overall majority in the parliament and given that the pro-Brexit faction of the Conservatives are demanding a stronger form of Brexit.

In the most market-disruptive case, Britain may be forced to leave the EU in March 2019 without an agreement. In this "no deal" case, Britain’s relationship with the EU may be reduced to that between WTO member nations. While some pro-Brexit politicians believe no-deal exit can free Britain to make better trade agreements with other countries, such as the US or other Commonwealth nations, in the short term this can be disruptive to the global financial markets.

Lastly, the current round of economic expansion has lasted over 100 months. We are no longer in the early parts of this economic recovery. It is perhaps not surprising to see some commentaries beginning to ponder how and when this expansion may end.

Recently, we have noticed that the US dollar yield curve has become very flat. Using July 15 data, the gap between 2-year and 10-year USD swap rates have dropped to below 10 basis points, with one year forward rates already inverted. When the cash yield curve inverted in the last nine cases, an economic slowdown followed in all those times. The credibility of the cash and forward yield curves comes from the fact that these rates are purely market driven, i.e. the rates are generated by someone who put their money where their mouths are.

We do not think that an economic slowdown is imminent. But we do believe that the interest rate environment has switched from a slow increase to one with largely halting rates where the society and the market sort out various geopolitical issues. This environment is still conductive for higher yield instruments like REITs.

As we have written in a recent Chinese book published in association with the Hong Kong Economic Journal, Asia Pacific REITs have had 15 years of development. We are now at a stage where REITs with good management strategies will continue to outperform those without clear strategies.

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Chief Investment Officer, Admiral Investment Ltd.