Between March of 2022 and May of 2023, the Federal Reserve has raised the Federal Funds rates ten times – taking it from effectively zero to 5.00% to 5.25%. Historically this has been one of the Federal Reserve’s fastest tightening sequences. The June 14th FOMC meeting marked the first time in more than 15 months that rates were not pushed higher.
While on the surface, the pause may seem like welcome news for investors, the underlying message from the Fed was not so positive.
Most analysts and economists were expecting a pause in rate increases this month, and markets were pricing in a drop in rates by the end of the year. The announcement of potentially two more 25 basis point increases this year caught many off guard.
To say that the markets hang on every one of Jerome Powell’s words may be a bit of an overstatement, but they do react to the Fed’s actions and signaled intentions.
Jerome Powell’s comments set a somber tone for what was otherwise welcome news.
In his opening remarks, Powell stated, “We are strongly committed to bringing inflation back down to our two percent goal” – nothing new here, but his words would darken as his comments progressed.
Chairman Powell went on to note that “the full effects of…tightening [has] yet to be felt” and that “uncertain lags” and “potential headwinds” need time to play out. As such, the Committee determined the best course of action was to leave rates unchanged.
Again, these remarks alone or out of context are unremarkable; in fact, they were widely expected. What came next was a central consideration for the lending industry, markets, and investors.
Powell stated, “Nearly all committee participants view it likely that some further rate increases will be appropriate this year.” As Powell would later elaborate, most FOMC members believe that rates need to be closer to six percent to return inflation to the Fed’s two percent target.
For markets that were pricing in a rate drop towards the end of the year, the likelihood of further hikes had a profound effect. The 10-year treasury rate jumped four basis points, and the 2-year treasury was up seven basis points almost immediately.
At the end of Powell’s prepared remarks, he laid out the committee’s vision of rates going forward. “If the economy evolves as projected…the federal funds rate going forward will be 5.6% at the end of , 4.6% at the end of 2024, and 3.4% at the end of 2025.” Recognizing the question likely to come, Chairman Powell further noted that “reducing inflation is likely to require a period of below trend growth and softening of labor market conditions.”
Taken together, Powell’s remarks send a clear message to the markets to not expect a reduction in the fund’s rate this year and a slow drop in rates over the next few years. There should also be no doubt that the Federal Reserve will accept a recessionary period to ensure that inflation returns to the two percent target.
When later pressed by reporters on the rate issue, Powell remarked, “As anyone can see, not a single person on the committee wrote down a rate cut this year. Nor do I think it is likely to be appropriate.” If there was any doubt in the Fed’s intent going forward, these last comments should leave no questions – the Fed has no intention to lower rates this year.
When asked about banks and commercial mortgages, Powell remarked, “There is a substantial amount of commercial real estate [debt] in the banking system – a large part of it is in smaller banks.” The Chairman further elaborated that he expected losses within this segment of the industry but that they would play out over time and do not represent a systemic threat to the economy.
Since the failure of Silicon Valley Bank, Signature Bank, and First Republic Bank in March and May of this year, the banking industry has been a focal point of scrutiny and speculation. While opinions on the banking system’s stability vary, there is no doubt that the failures have played a role in the current credit crunch. The tightening of credit availability, increasing interest rates, and overall market conditions have created unfavorable conditions for many borrowers.
As noted earlier, the FOMC pausing rate increases would otherwise be welcome news. However, the Fed signaling a high likelihood of more rate increases this year and no cuts in the coming months does not bode well for many investors.
Market conditions were already making it difficult for multifamily buyers and sellers to transact, and the potential for higher rates will not improve the situation. CMBS data examined by CoStar and CRED iQ show an increase in troubled properties and the maturity default rate. Between January and March of 2023, there was a $3.7B increase in new maturity defaults, and between May and June of 2023, there was an 8.7% increase in troubled multifamily properties backing CMBS loans.
Gray Capital CEO Spencer Gray sees uncertainty in the next six to 12 months and the potential to acquire some “incredible assets…at a significant discount.” Gray Capital is not the only group that sees opportunity on the horizon. In the latter half of the year, J.P. Morgan Private Bank expects to find opportunities across asset classes in multiple markets.
Most opportunities will likely come from distressed owners who cannot refinance their maturing debt. A profitable property on an interest-only note at three percent may no longer be suitable when refinanced at seven percent. In truth, the property may not be financeable without a significant equity infusion.
Is there a tidal wave of distressed properties coming – unlikely. As Jerome Powell noted in his remarks, this problem will slowly evolve and unfold over the next 12 to 24 months. Lenders will most likely work with borrowers to prevent a default, and it will only be the properties that are too far underwater or owners that can’t raise the necessary equity which will succumb to market conditions.
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