• The Fed raised interest rates by 25 basis points today and appears poised to make one additional rate hike this year.
   
• Despite the Fed’s interest rate increases, cap rate increases have been limited as long-term interest rates have remained stable.
   
• Further flattening of the yield curve (the difference between long- and short-term rates) would be a cause for concern as an inversion has precipitated most recessions.
   
• The Fed provided greater forward guidance on how it plans to shrink its balance sheet, which will begin later this year.

The Federal Reserve raised interest rates by 25 basis points (bps) today, lifting the target range for the federal funds rate to 1.0%-1.25%. This is the third 25-bps increase since December 2016. The Federal Open Market Committee (FOMC) now expects to make one additional increase this year. In addition to generally good economic conditions, commercial real estate fundamentals remain strong, and improved economic growth may lead to an extended cycle. Given that this was a well-telegraphed move by the Fed, capital markets will likely react with a fair degree of calm.

From a real estate perspective, cap rate increases have been relatively muted as the long-end of the curve has actually decreased in 2017. Most of the very modest cap rate softness in 2017 is related to fundamental concerns about certain market/asset types being near the top, in addition to some secular concerns about retail. Overall uncertainty related to market fundamentals and interest rate movements has led to lower transaction volumes and many potential sellers opting instead to refinance their properties.

The Fed currently holds $2.5 trillion in U.S. Treasurys and $1.8 trillion in mortgage-backed securities (MBS), and has maintained these levels by reinvesting in new securities as its holdings mature. Starting later this year, the Fed plans to slowly phase out these re-investments by letting a small amount of its securities holdings mature each month, thus shrinking its balance sheet in a controlled manner. The net maturities will initially be capped at $6 billion in Treasurys and $4 billion in MBS per month. These caps will be raised each quarter and eventually reach a maximum of $30 billion in Treasurys and $20 billion in MBS per month. The Fed offered no target for its balance sheet reduction.

With one of the largest buyers of sovereign bonds and agency debt systematically exiting the bond and mortgage markets, long-term rates will likely rise. The Fed also made clear that the shrinking of its balance sheet could stop if there was a “material deterioration in the economic outlook” and that the federal funds rate will remain the “primary means of adjusting the stance of monetary policy.” 

Overall, no one should have been surprised by today’s move, as Fed officials did a good job of communicating their intentions in recent weeks. The Fed has indicated it is on a path where rate hikes should be assumed unless the data says otherwise. Going forward, wage and inflation data will be particularly influential, as will legislative progress on fiscal policy. 

Finally, one other factor to watch is any announcement regarding Janet Yellen’s term as Federal Reserve Board chair, which expires in February 2018. The market is likely to look for signals on her reappointment or replacement later this summer. A lack of clarity could negatively impact the markets.