The Federal Reserve’s tight monetary policy, which has pushed short-term rates above 5%, is beginning to take its toll on the equity and debt markets.
Traders and investors have been selling stocks and Treasury bonds this week following the September FOMC meeting, where the nation’s central bank indicated that it will continue fighting inflation.
As a result, equities had the worst week in the last six months, with the S&P 500 losing 3.6% of its value and Dow Jones and Nasdaq experiencing similar losses. In addition, Treasury bond prices continued declining, with yields reaching the psychological level of 4.5%.
The simultaneous decline in equity and bond prices was a big blow to traders and investors who bought both assets a year ago, expecting that the Fed would engineer a soft landing and pivot by the middle of 2023.
Still, history has shown that the negative impact of rising U.S. interest rates could spread to other markets at home and abroad. For instance, in the 1990s, rising U.S. interest rates fueled the unwidening of the dollar carry trade, crashing the Mexican and the Asian emerging markets.
In addition, rising interest rates in the early 2010s caused a multiple-asset crash, pushing the U.S. economy into a great recession.
While it’s too early to say whether the U.S. economy is heading into another recession this time, market observers expect history to repeat itself, with higher interest rates taking their toll in other markets.
Top on the list is commercial real estate, which has already been under pressure since the break of the Covid-19 pandemic.
“For the past decade, commercial real estate and corporate borrowers and lenders were feasting on lower and lower yields and increased government spending,” Brett Forman, Principal at Forman Capital, told International Business Times. “It allowed commercial real estate assets to trade at higher values – which translates to lower-yielding cap rates. This was fueled by the availability of low-interest rates and the abundance of debt.”
But interest rates are no longer low, and they keep getting higher, making it harder to refinance these properties. “Real estate loans are maturing every day, week, and month. It is quite simple,” Forman explained. “Higher interest rates make it difficult to refinance. The properties are not throwing off more cash because of the interest rates. In some cases, with increased expenses and rents topping out or declining, the cash flow will decrease.”
Next on the list is the market for multifamily homes, which still looks solid. But it won’t stay that way as mortgages continue to climb.
“Yes, multifamily is strong, but multifamily was the easiest asset class to finance and could achieve more debt as a percentage of value at lower spreads,” continued Forman. “My thinking is multifamily was priced to perfection. Therefore, when it’s time to refinance or sell, the debt is less abundant and far more expensive. This will necessitate a re-setting of values.”
Luke Stone, Senior Investment Analyst/CFA at Winthrop Capital Management, believes that higher interest rates will extend beyond the multifamily sector to the entire housing industry.
“We see the potential for the Federal Reserve’s prolonged tightening policy breaking the housing market,” he told IBT. “Mortgage rates have reached a 20-year high resulting from sustained rate hikes by the Federal Reserve, hitting 7.50% after nearly a decade of historically low rates. This spike in mortgage rates has slowed home purchases and affected the psyche of home buyers.”
Stone presents a U.S. news survey, which shows that 84% of home buyers purchased to refinance in the near term. In addition, 13% of buyers said they could not afford their initial payment, relying on the potential for future refinancing. “If the Federal Reserve prolongs their tight rate policy, we may see forced selling from homeowners that cannot afford their monthly payment,” Forman said. “Further, with the effective interest rate on mortgage debt at 3.60%, we see many homeowners refusing to leave their current home, limiting the demand in single-family homes.”
He believes the excess supply generated from forced selling could be bad news for the housing market. “When met with limited supply from comfortable homeowners, it will cause precipitous drops in home prices.”
Niladri Mukherjee, Chief Investment Officer, TIAA Wealth Management, thinks that what matters the most for markets is the length of interest rate hikes,” he said. “The longer this time frame, the more the economy is likely to slow, and higher bond yields will cause equity volatility to rise. Investors may have to reassess the corporate earnings picture for 2024. It will be important for investors to remain diversified across multiple asset classes and adhere to their long-term portfolios during this stretch.”