If The FED Tells You Something, You Should Believe It

The most notable change over the past two years in the economy, which has dramatically shifted the real estate market, has been the rapid rise in interest rates. Elevated inflation, which was the result of massive stimulus and supply chain disruption during the pandemic, was the catalyst for the Federal Reserve increasing their funds rate over 500 basis points since the start of 2022. This increase in the short-term rate has resulted in long-term treasury yields tripling during this time, and mortgage interest rates mirroring this trend. The FED has been unwavering in their commitment to cut inflation and chairman Jerome Powell has been very direct in his commentary that they would not stop until the job is done. Despite this tough talk, the bond markets had previously priced in a shorter duration of restrictive policy and rate cuts in the more near term, along with a near 100% chance of a recession before the end of 2023.  

While inflation has been showing signs of subsiding, the economy, most notably job and consumer data, as well as GDP, remain strong, so the FED has indicated that rates will likely stay higher for longer. While the FED funds rate is relevant to long-term bond yields and mortgage interest rates, to assume that these would come down as inflation becomes less elevated is an oversimplification of the supply-demand problem with bonds. Higher bond yields and interest rates due to inflation have been assumed to be temporary, and the FED appears to be done with the current rate hiking cycle, however inflation expectations and the FED’s response to the same are not the only thing that causes bond yields, and thus the interest rates we pay, to increase. 

Aside from the FED funds rate, which most impacts short-term bond yields, an increase in long-term yields has been tied to changes in supply and demand for these bonds. When the United States spends more than it makes, known as a budget deficit, the extra money has to come from somewhere, and that difference is funded by issuing debt in the form of bonds. The United States Treasury has announced that they will continue to issue and sell treasury bonds to fund the budget deficit spending. Additionally, the reversal of quantitative easing, bond buying done to lower interest rates during the pandemic, is the allowing of maturing treasuries to fall off of the FED’s balance sheet at the rate of $90 billion per month. At the same time, China, the largest holder of U.S. treasury bonds, has reduced their holdings by over $62 billion year to date. All of these result in a greater supply of bonds on the market. Now at higher interest rates, these bonds will require more money to be spent on servicing the debt (approximately $5 billion per day), therefore requiring more debt to be issued, at a time when there are fewer buyers. When supply exceeds demand, it is necessary to sweeten the deal to get investors to buy more, which is done by reducing the price of bonds, increasing the bond yield being offered, thus resulting in higher interest rates and more debt service obligations, creating a vicious cycle. 

In addition to this worsening debt burden, the political situation in Washington could not be more troublesome. After narrowly averting two government shutdowns so far in 2023, the speaker of the house of representatives, Kevin McCarthy, was ousted by his own party, due to his desire to compromise on long term spending cuts to increase the debt ceiling. A new speaker of the house was recently elected, and his hardline conservative leanings make a compromise to extend the debt ceiling without a government shutdown less likely. While, at the time of this writing, this might be averted with another short-term funding deal, the constant political brinksmanship has led to debt downgrades and negative outlooks by rating agencies, which can cause investors to demand a higher risk-adjusted return for U.S. debt vs. other assets. A harder line approach to cutting spending might improve the federal budget and debt situation in the long run, if politicians can agree on this, however in the short-term, the constant flirting with the proverbial “fiscal cliff” could increase borrowing costs for the U.S. government (and everyone else). 

The real estate market is very sensitive to interest rates, so a prolonged high-rate environment will continue the trend of low affordability leading to muted demand. Without lower interest rates, affordability relief for buyers can really only come in the form of real estate price decreases or wage gains. Higher rates for longer likely means prices will need to decline or plateau, especially in areas that are less affordable to begin with, along with a continuing population shift to lower cost areas. While inflation coming down in the near term could help somewhat, the long-term goal of balancing the federal budget and getting our national debt under control, as well as the bumpy political path to get there, is a cause for concern. So, if the FED says “higher for longer” you better believe them, although the market might just do the job for them.