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Federal Reserve to Embark on Normalization; Balance Sheet Reductions to Influence Commercial Real Estate
Balance sheet normalization likely to begin. Following the rounds of quantitative easing that pushed the Federal Reserve’s balance sheet to $4.5 trillion, the Federal Reserve has outlined plans to reduce the size of its holdings. This will accelerate its effort to move toward more normalized monetary policy following nearly a decade of easing. Although the Federal Reserve has raised short-term interest rates four times since the financial crisis took them to zero, the balance sheet has remained consistently near $4.5 trillion as interest and proceeds from investments have been rolled over into new securities. However, that process is about to change, with members outlining plans to allow $6 billion of Treasury securities and $4 billion in mortgage-backed securities to roll off the balance sheet per month to move toward normalization. The Fed plans to gradually increase the amount allowed to mature to $30 billion in Treasurys and $20 billion in mortgage-backed assets as the process moves forward. The winddown is expected to transpire at a cautious pace over several years, with a primary focus on market stability.
Fed normalization to place upward pressure on longer-term interest rates. A winddown of acquisitions by the Fed, one of the largest buyers of long-term debt, will exert upward pressure on long-term rates. Additionally, market liquidity could decline for other asset classes as participants adjust to the resulting rise in risk-free rates. This process could slow demand for bonds originating from weaker capital structures as capital markets adjust to reduced liquidity. However, interest rates remain historically low, encouraging market participants to purchase higher-yielding assets to achieve targeted rates of return. This will partially counterbalance upward pressure on interest rates. Additionally, investment flows from foreign markets to the United States in search of higher yields and safe-haven assets could restrain the pace of rate increases. As a result, upward pressure on yields will at least be partially offset by foreign and domestic buyers who favor the safety of U.S. Treasurys, particularly given the positive yield premium when compared with similar offerings overseas.
Rising cost of capital could weigh on investor activity. The majority of commercial real estate investors expect a modest increase in interest rates over the course of the year, pushing up the cost of capital. While commercial real estate fundamentals remain strong, rising costs associated with debt financing will tighten the spread between cap rates and lending benchmarks. This environment could weigh on transaction activity as investors evaluate their yield options. Cap rates have remained relatively stable over the last year, but upward movement in Treasury rates has amplified the expectation gap between buyers and sellers. Some anticipate short-run declines in the Treasury yields, reiterating that the untested moves by the Fed could increase rate volatility.