Let's have a Frank Discussion on Interest Rates...

[Wayne 962]

Just posted this on Reddit, I figured it would be entertaining for everyone here?

Let me start by saying it’s difficult to predict the future, because there are many different factors that influence markets. These factors may be absolutely true, but what many people don’t realize is that it’s difficult to measure what I call “Scope and Scale”. Example: you can pee in the ocean and it will technically raise the level of the ocean up a infinitesimally small amount. The melting of ice shelves also raise the level of the ocean, but their impact is much greater. This is an extreme example that I use just to make a point. People who say “peeing in the ocean is raising the level” and “melting ice caps are raising the ocean” – they both are right, but one doesn’t really matter as much as the other.


That’s a good pretext to interest rates. There are a lot of different factors that influence interest rates, specifically mortgage rates for both homes and commercial properties. I personally think that rates are likely to keep going up, based upon events that are happening right now, and will happen in the near future. I have two in particular that I have been watching and I think these two will have significant “scope and scale” on the mortgage rate market.


The first one is Treasury debt. First of all, nearly everyone on the planet seems to think that Powell sets mortgage rates by changing the FED overnight lending rate, sometimes called federal funds rate. Same thing. No need to go into details on what this is exactly (see here for more info: https://www.investopedia.com/terms/o/overnightrate.asp), but people confuse this with “mortgage rates”. They are not the same. The overnight lending rate does *influence* mortgage rates but they aren’t the same. Sometimes a movement in the overnight lending rate has no or little effect on mortgage rates. Here’s another quick article that tries to explain: https://www.stlouisfed.org/in-plain-english/the-fed-implements-monetary-policy


Anyways, the mortgage market is considered to be a “safe” investment, and by near definition, the safest market available is the US Treasury market. So, the US mortgage market almost always moves in tandem with the US Treasury market. If rates on Treasuries go up, then mortgage rates go up. Some banks specifically peg their current mortgage rates to the Treasury market. With my bank and commercial loans, it’s typically the 10-year Treasury note + a bank spread. The spread is what you negotiate on when trying to get a mortgage – the base is set by the Treasury market.


The Treasury market is an *auction* market, with rates set *solely* by people and organizations who are actively buying bonds. Pretty much like the stock market. Very, very efficient, without many dislocations. This means the price is set by supply and demand – just like many people learned in Econ 101. What happens if there are a lot of people wanting to buy US Treasurys? (yes, it’s spelled that way – that’s not a typo). The interest rate paid on the bond will go down. What happens if there’s an auction and there aren’t many people who want to buy Treasurys? Then the US Treasury (the government) will have to raise rates in order to attract more buyers. It’s very simple. The up and down of this Treasury market is what determines the prevailing mortgage rates. Not Powell and the overnight lending rate. There could be hours-long discussions on the relationship between the overnight lending rate and the US Treasury market, but that’s a discussion for another day.


So, if mortgage rates closely track the Treasury market, and the Treasury market is solely determined by supply and demand, then people who want to try to predict interest rates should probably look to the supply and demand that will be occurring in the near term. Cutting to the chase, the US Treasury (the government) will be issuing a record amount of US debt in the remaining half of this year. This will cause a supply increase. Without a corresponding increase in buyers (typically the Chinese, Japanese, etc.) then the US government will have to offer a higher rate in order to attract more buyers. More info on this here: https://fortune.com/2023/07/31/how-big-federal-debt-deficit-treasury-bonds-auction-markets/ (sorry if behind a paywall).


I might add a little note here on who some buyers of Treasury debt are – the Chinese. Why would the Chinese buy US Treasury debt? The answer is simple – they make stuff, we buy the stuff, and we pay them in dollars. Theoretically, dollars are only useful for stuff in the US (the home country). Since the dollar is considered a reserve currency the world over, that’s not necessarily true, but for the sake of this discussion, we’ll assume that payment in US dollars means that they have to buy “stuff” with those dollars. Since we have a trade imbalance with China, we give them a lot more dollars (basically IOUs in our currency) for the stuff that we buy in Walmart, the iPhones, and other Chinese goods, etc. With all of this trade, the easiest thing to do with the US dollars is to turn around and buy US Treasuries. I think they own about a trillion of the bonds right now. Anyways, bottom line on this – as purchases from China are scaled back (for many reasons), the corresponding demand for US Treasuries goes down. Ironically, the more stuff we buy from China, the more that they will want to buy US Treasurys, which will keep the rates down.


So – A wave of Treasury debt is coming, and it’s unknown what the demand will be for that debt. If demand is light, then they will have to raise rates to attract new buyers.


Second point – banks. Without going into intense detail (I can do that in a follow-up reply), many banks these days are suffering from not-so-good assets on their loan books. Just look at all of the office properties being handed back to banks - Exhibit A. I few months ago, I called several banks that my good friends have great relationships with. My friends said “Call my guy ‘Joe’ at XYZ bank – he’ll hook you up”. So I did. All of them said, “we’re not lending right now”, or “we’re only lending to people who have an existing relationship with us.” Wow, it doesn’t take a PhD from MIT to figure out that if the banks aren’t really keen on lending right now, then they (or their competitors) will be more picky. More picky means higher credit requirements *and* the ability to charge a higher rate. If you go to five banks and four say “we’re not really lending right now” the fifth bank can pretty much charge what it wants to lend the money (within reason, of course). I have seen this driving up interest rates already (this would be the spread I mentioned previously – placed on top of the baseline Fed Funds rate).


Anyways, there you have it. These are just my thoughts on the influences affecting interest rates today. It’s nearly impossible to predict demand for Treasuries and impossible to predict the bank’s appetite for new loans, but one can certainly see factors that would affect those two both positively and negatively. When rates were at 3%, I told everyone that I thought they would normalize at about 7.5% - about what they were in the early 2000s. Most people thought I was Chicken Little, but better safe than sorry. Now I think they are poised to go higher, at least in the short term, due to at least these two factors I mentioned here. I certainly could be wrong and these two factors could be negated by something else. But that’s what the discussion is all about?


Cheers…

https://www.reddit.com/r/CommercialRealEstate/comments/1696zyw/lets_have_a_frank_discussion_on_interest_rates/

[pwd72s]

Wayne, you seem to ignore the federal spending spree as a factor. That raised the inflation rate. Powell has a target of a 2% inflation rate, is raising the interest rate in an attempt to curb inflation. Yet for political reasons he isn't crying; "It's the spending, stupid!"

The Biden congress didn't spend like drunken sailors. Drunken sailors quit spending when they run out of money. Congress refuses to do that.

Sorry if I just sent this into PARF...hope I didn't.

[Soterik]

Ok, so no banks (except owner occupied sba)... but credit unions, cmbs (well those are banks...),... fannie, freddie, lifecos. There's private debt, but those guys can also buy treasuries and not worry.

Are you trying to buy something? You should talk to my wife (you did once before, but it was a long time ago...). She's with Marcus & Millichap now (on the debt side). How do you think I get my cars...??

[jyl]

I personally think that yields (rate) should be higher. Very low yields inflate asset prices, encourage speculation, and penalize savers. 4.2% on the 10 year is not too high. 6% feels more desirable. Sure, that implies mortgage rates 9-10% which won’t be good for house prices, but house prices have soared in the past decade, some giveback won’t kill us. Ditto other asset prices.

Where will yields go? One way to look at it is relative to GDP growth. US GDP is growing around 6% nominal (4% inflation plus 2% real GDP growth; note the GDP growth figure discussed in media, reports, etc is real). That’s higher than China’s nominal GDP growth, by the way. If the economy grows 6%, a ten year yield 200 bps below that seems too low. Tie up money for ten years for a return lower than GDP growth - not so attractive.

Another way to look at it is demand-supply, but that is incredibly hard to figure out, no-one reliably can. So many buyers for Treasuries, with so many different reasons and motivations. The supply side is growing fast, that’s true, but buyers have shown up in force for the upsized Treasury auctions so far.

Bonds have been a winning bet for many decades, as yields have declined. That one-way street is over. Investors have lost money on Treasuries for the last two years and look to be losers for a third. Going into 2023, there were a lot of calls to buy Treasuries notes and bonds as there hasn’t been a three-year losing streak for - well, ever maybe. I didn’t see the point, not when bills are yielding 5%+ with no duration risk. Still don’t.

[GH85Carrera]

Back when I was struggling to buy my first house, interest rates were 18% average and I got a fantastic super deal of only 12.5% on my first house. I no super cash to put into investments back then. When I finally built up some cash to put into a CD the rates were stupid low. The stock market was the only logical place to put any assets.

With the current situation, I don't see interest rates going back down anytime soon. Fortunately for me, I have no debt except an loan for my company loan on an airplane, and have way over 50% equity in the airplane so I told the bank I want a fixed rate loan almost two years ago, so it is a low rate. My loan officer whined the bank would make less money and I told him not my problem, we can find another bank to carry the loan and he knew it.

[john70t]

Originally Posted by pwd72s

Wayne, you seem to ignore the federal spending spree as a factor. That raised the inflation rate. Powell has a target of a 2% inflation rate, is raising the interest rate in an attempt to curb inflation. Yet for political reasons he isn't crying; "It's the spending, stupid!"

This. Plus student debt will be hitting the tables and no more bankruptcies allowed. A.I. will be huge and taking over a plethora of jobs. Downtown RE is not recovering from the Covid1 era and people working from home will lower tax income from cities, which will have to raise prop tax, sales, gas, registration, paid roads, etc. Manufacturing has been MIA a long time. IP goes out the window as soon as the colleges create it. Education is null for the next generation and public outlook is heading into a steep dive. Boomer inheritance money is in the cross hairs of the IRS https://www.zerohedge.com/personal-finance/new-inherited-ira-rules-mean-heirs-could-be-left-large-tax-bills. etc. I've missed a few but you get the gist.

A 'soft landing' with slowly increasing interest returns in bank investments will not keep up with true CPI/COLA, and savings will be whittled away sitting in an account or bonds.

That traditionally means a flood of money into RE which will make rental housing unaffordable again. Ask me about ownership with property taxes and utility costs which will trickle down eventually, like it or not. This might equate to a further flood of people moving away from big cities.

Everything is getting squeezed so the last bastion of hope to retain value will be the stock market gambling circuit again. 15% ensures that, but it is another golden egg to be removed from a plucked goose. Not necessarily in this country, not necessarily by these citizens. The rest of the world has it's problems as well. There is a global trend which can't be discussed here. I have no further positive advice to add to this conversation.

[Por_sha911]

Who is the biggest borrower of money? Uncle Sam (and has been the case for many decades so it is not the fault of one person or party).
Factor that into the equation.

[jyl]

I think there’s some major positives out there.

Manufacturing. Construction of and investment in new manufacturing facilities is booming, absolutely booming. Companies want to reduce dependence on China supply chain, CHIPS is driving huge growth in US semiconductor fabs and related facilities, IRA is driving huge growth in all types of renewable energy facilities and manufacturing (EV, batteries, solar, wind, power storage, you name it). Judging from the investment dollars, we’re on the cusp of a manufacturing resurgence in the US. It will be mostly high-tech manufacturing, lot of automation, also a lot of jobs. China will try its standard tricks of subsidizing and dumping goods to undercut the US production, but the US will block that with tariffs and import restrictions - the gloves are off. I suspect the challenge will be to staff the surge in manufacturing positions, with labor so tight. Eventually, all that new manufacturing should generate more tax revenue too.

Student loans. A non-issue overall, though there will be some vocal losers. US consumer spending is $57 trillion/year, so $100 billion in resumed student loan payments isn’t a needle-mover.

Downtown office buildings. A lot of buildings will be foreclosed, the rest will lose a lot of value, their investors will lose a lot of money. Banks will mostly muddle through as they hold only a small part (EDIT: looked it up, not that small, about half?) of office property debt, it is a fairly small part (EDIT: typically around 10% for small banks, much less for large banks) of their loan book (in most cases - there will be a few sad banks who bet big), and the loan to value is typically around 50-60% which means their loss will only be a small part of the loan. On the other hand, tenant companies will enjoy lower rents for better space and a small amount of the foreclosed office buildings will be be converted to apartments and condos. Basically, there will be winners as well as losers.

Tax base. Yes, local taxes from downtown office districts will decline and other taxes will rise, suburbs and exburbs will enjoy more revenue. Again, winners and losers.

Savings. Savers are doing better than they have for decades, with short term rates at 5% which is higher than CPI inflation. Is CPI inflation over or under-stated, it depends on the individual. Own your house with no mortgage or a fixed rate mortgage from before 2022, modest tastes, your personal CPI is lower. Rent and go out to eat all the time with lots of travel and a new car every few years, your personal CPI is higher. Most of us on PPOT should be on the lower side. Inflation is probably going to decline at least somewhat over the coming year (because housing is appx 36% of the CPI basket, both rent growth and house price growth have slowed to flattish over the past year, and that should start pulling CPI down - the housing inflation part of CPI actually looks to have peaked and started easing, over the past few months). But the Fed is probably going to hold short rates here for awhile, meaning money market funds and the higher yielding CDs will increasingly beat CPI. As for long bonds, well, I am still not a buyer, but hopefully before long it will be possible to lock in 5% or more in Treasury notes and recall that interest is exempt from state/local tax, so for residents in high tax areas that’s rather interesting.

Federal debt. I don’t think current deficits are sustainable, fortunately deficits are somewhat self-correcting. Eventually Washington raises taxes, closes loopholes, increases enforcement, slows spending, and - as always - there’s winners and losers. I hope the “losers” are the ultra-wealthy and the companies who have 80% of sales in the US but somehow report 70% of profits in Ireland and similar tax havens, but we’ll see. If it’s any consolation, China is way “ahead” of the US in total debt-to-GDP and you’re seeing the debt mountain starting to sag and crack there.

[Por_sha911]

Originally Posted by jyl

Student loans. A non-issue overall, though there will be some vocal losers...$100 billion in resumed student loan payments isn’t a needle-mover.

Tell that to my daughter who is about to graduate with her Masters Degree and a bill school loan. So, what you are saying is it isn't a big deal if it doesn't hurt you?

[Planter91C2]

Originally Posted by Por_sha911

Tell that to my daughter who is about to graduate with her Masters Degree and a bill school loan. So, what you are saying is it isn't a big deal if it doesn't hurt you?

Was she unaware what a loan is?

[Vintage Racer]

Wayne is suffering with getting only a 5% yield on his 29,000,000.

His tax bills are excessive.

[jyl]

Originally Posted by Por_sha911

Tell that to my daughter who is about to graduate with her Masters Degree and a bill school loan. So, what you are saying is it isn't a big deal if it doesn't hurt you?

It’s a big deal to her. To the US economy as a whole, not so much.