The standard opinion is that long-term rates (e.g., the U.S. 10-year Treasury) are more relevant to the pricing of commercial real estate than are short-term rates. The current consensus is that the short rate will rise to 2.2%, while the long rate will “settle in” at 3.2% over the next few years.
Below I offer some thoughts on the factors that historically have governed the relationship between these two rates, and suggest a new one for the future.
Short-term rates. There is no doubt that long-term rates embody short-term rates. The two do not move anywhere near proportionately, however. Although they have correlated positively over the last 20 years, the premium on the 10-year has ranged between zero (in 2007) and 3.5% (in 2004), with an average of 1.5%. What will the 10-year rate be in 2020? The shape of the yield curve will be a more important determinant than the short rate at that time will be.
Normal movement in the government yield curve. One of the most intuitive theories is that the long rate is the present discounted value of expected future short rates over its term. When the yield curve is nearly flat (as in 2000 and 2007), the market expects significant declines in the short rate. When the curve is steep (as in 2004), the market anticipates future rate increases. So if we think the short rate will rise to 2.2% and stay there (the consensus forecast), then the long rate might settle at its average premium of 1.5%—giving us 3.7% for the 10-year. The problem is that with paired fluctuations in GDP growth and inflation, the short rate never stays in one place for very long. So if the next five years brings us labor shortage wage increases, import-restricted goods inflation, and larger deficits, the resulting CPI inflation may lead the Fed to raise rates above 2.2%, which will cause the economy to slow and ultimately bring short rates back down again.
Abnormal movement in the government yield curve. Over the past decade, central banks in many countries hit the “lower bound” (zero) for short rates, attempting to recover from the Financial Crisis. As some tried charging negative rates for parking money safely, the U.S. Fed engaged in asset purchases of long-term Treasury and Agency debt—to the tune of $4.5 trillion. This “quantitative easing” led to a 1.5% drop in the long rate (against a zero short rate) over 2011-2014. Most central banks are now considering “unwinding,” or the sale of these acquired assets. Even if done cautiously, could this not add 1.5% back into the slope of the yield curve for a number of years?
Changes in the demand for and supply of investment capital. Most countries are now entering a period wherein their populations “age” significantly. With this demographic change, household savings rates should drop significantly. This has already occurred in Japan—the first nation to experience this aging. On the other side of the market, demand for investment and capital should only grow. Under-funded public pensions can supply the growing pool of elders only with further government borrowing. Meanwhile, there is widespread belief that infrastructure in developed countries needs serious infusions of capital. Finally, climate change will require drastic increases in investment just to mitigate its impacts. The IEA estimates that $1 trillion of additional investment is needed annually to transition our energy systems to renewable sources. Many additional trillions will be needed to develop flood control systems, to redesign cities, and to move populations away from coastlines. An inwardly shifting savings schedule and outwardly shifting investment demand can only raise rates.
Let’s take stock: A short rate of 2.2%, a normal 1.5% long-term premium, plus another 1.5% from “quantitative unwinding,” plus the start of the long-term capital requirements of climate and aging… Giving us a 10-year of just 3.2%? Doubtful.