bonds market Archives - Insignia Mortgage

Yields Rise As Strong Wages All But Ensure Fed Rate Hike

The ADP report this Thursday marked a significant week for the bond market, as both Treasury and Mortgage rates exhibited a notable increase. Fortunately, Friday’s employment report met expectations, easing some pressure on bonds. The probability of the Fed raising rates later this month is now nearly 100%, with elevated wage inflation and the strong job market. In addition, bond traders are realizing that interest rates will remain high for an extended period, due to persistent global inflation and forecasts of potential interest rate hikes in other countries (like the UK).

Some argue for the Fed to exercise patience and assess the long-term effects of their rate hikes on the US consumer and the economy. Despite this pushback, there are signs that the rate increases are making an impact. Banks are becoming more cautious with their underwriting box, consumers are exercising caution in their purchases, manufacturing data is declining, and credit card balances are rising as stimulus funds dwindle. One might wonder where we would be if the AI investment theme didn’t re-ignite animal spirits. Additionally, large apartment investment firms are facing challenges as floating rate debt reaches a tipping point, where monthly interest expenses exceed property cash flow. The pain of higher interest rates is gradually spreading beyond the office sector to other real estate asset classes.

An illustrative example demonstrates the risks of buying at very low cap rates:

2021 Investment Environment Net Operating Income: $100,000 Cap Rate: 3.75% Value: $2,667,666
2023 Investment Environment Net Operating Income: $100,000 Cap Rate: 5.75% Value: $1,739,130

This example equates to a loss of almost 35% on the property due to the movement in cap rates. While we don’t anticipate a systemic crisis in commercial real estate, buyers who relied on aggressive assumptions and maximum leverage may face difficulties ahead.

Rate Hikes & Real Estate: What’s Next?

Higher interest rates are influencing the existing housing market, resulting in continually elevated home prices, despite interest rates returning to 7%. This situation may limit what potential buyers can afford. Furthermore, the potential for an increase in housing supply seems plausible if equity markets reverse course in response to ongoing Fed rate hikes. Sellers may choose to sell their homes while existing home market inventory remains tight, rather than waiting for a recession or other negative events. Notably, the Southern California superluxury market is experiencing a swell in inventory as ultra-wealthy individuals are less inclined to expand their home portfolios. It will be intriguing to observe what factors will entice these buyers back into the market. Only time will reveal the answer.

Strong Jobs Report Supports More Fed Tightening

Concerns over the Fed’s progress on quelling inflation have been heightened considering May’s solid Jobs Report. The 10-year Treasury Bond is now nearing 3.000%. The Fed has publicly stated they see no reasons to pause rate hikes (even after the expected 100 bp hikes expected in the summer) and the Jobs report has reinforced a tight labor market. Inflation will not come down for some time. It may have peaked, but the slide to lower inflation is expected to linger. Since labor makes up over 65% of corporate expenses, rising incomes will continue to put pressure on companies to raise prices when possible. Additionally, commodities inflation (especially oil) remains high. Case in point, gas prices hit $8 per gallon in California recently.

Lookout: The June Balance Sheet & Major CEO Premonition

Expect ongoing volatility as the Fed is willing to let markets fall to wring inflation out of the system. This includes equities and housing. I advise you to watch the Treasury market closely. The Fed begins to run off its balance sheet in June, but the real action begins on June 15^th. It will be interesting to see the effects of QT after so many years of liquidity support in the financial system by the Fed. This reinforces the need to be a fundamental thinker when buying real estate, a home, or any other security. Price always matters.

Some major CEOs are beginning to warn of a looming recession. These individuals have access to troves of data and have the best minds in the world advising them. It goes without saying that the economy is too complex to truly predict what could happen. Economists and forecasters get things wrong more often than not. However, all this negativity is causing banks to be more cautious in underwriting. The need for volume is creating competition for high-quality loans. Rate spreads are tight as banks compete to obtain the safest credit candidates in the jumbo space. Non-QM and alternative documentation loans have fallen out of favor with the investor community. Such products are not getting a bid in the secondary market. Insignia remains focused on portfolio lending solutions for our customers who are mostly self-employed or foreign nationals.

The combination of a slowing economy and elevated inflation is a worst-case outcome for the economy. The Treasury market leads the way as a signpost for where the economy is headed. In some ways, we must hope for higher long bonds as an inverted yield curve portends recession. Given all the debt in the system, one must not forget that things can still get worse.