Interest Rate Fervor

Not to beat a dead horse, but commercial real estate loans are beginning to resemble the weather patterns on the East Coast: totally unpredictable. Triggered in part and seemingly counter to the Fed's decision on July 16th to keep rates low, we've witnessed another firestorm of interest rate volatility that has both borrowers and the commercial mortgage markets scrambling to lock in rates and hedge positions. What I'd like to do is examine the key drivers behind the very recent interest rate fluctuations in the loans market.

Federal Reserve Chairman Alan Greenspan met with the Federal Open Market Committee (FOMC) today (Aug. 12th) to announce their unanimous decision to leave the Central Bank rate unchanged at 1%. The resulting effect as reported on Bloomberg stated, "The yield on 10-year Treasury notes is up more than a percentage point from 3.25 percent the day before the last Fed rate decision on June 25, and the average yield for investment grade corporate bonds of similar maturity has risen by almost a full percentage point, to 4.823 percent from 4.023 percent."

Stocks were up today and bonds were down - as money flows into the stock market and away from the bond market, bonds need to lower their prices while increasing yield in order to attract investors back. With bad news in the economy, we generally experience a flight to quality, i.e. bond market rallies and the yields come down - with good news circulating, the opposite is true. So we have this constant push/pull effect occurring between the equities market and the bond market.

"They're trying to assure the bond market, in very blunt terms, that they're not at all thinking about raising interest rates at any time in the near future," said Lyle Gramley, a former Fed governor who now serves as a senior adviser at Schwab Capital Markets in Washington. "In my judgment, they're right -- I don't think this economy is off to the races." During their last meeting, Greenspan indicated that the Fed would keep interest rates at their 45-year historic low for as long as necessary to allow for "satisfactory economic performance" to resume.

As reported in the Wall Street Journal, "he said that while such a commitment should hold down short-term market interest rates, long-term rates such as those on 10-year bonds (that's us) would also respond to other forces, including expectations of inflation, growth and the demand for credit. The Fed ordinarily boosts spending by lowering its target for the Federal funds rate, charged on overnight loans between banks, which then ripples through consumer and business loan rates."

Every report I've seen indicates that the Fed is unlikely to resort to "unconventional" policies such as buying bonds to lower rates in order to stimulate the economy - but rather would stick to its current tact of containing the Fed funds rate to 1% or even 0% before exploring alternatives. Buying Treasury bonds = reduced supply = higher prices = lower yield.

Greenspan's words quickly transformed to reality as long-term rates reacted immediately to other economic forces. Consensus has quickly formed within the marketplace that prospects for growth have risen as news of increased productivity and continued improvement in jobless claims. Accelerated growth in GDP from 2.5% to 2.75% this year implies that growth may pick up to an annual rate of 3.5%, and the Fed sees growth between 3.75% to 4.75% for next year - which is more optimistic than private economists who view next year's growth closer to 3.7%.

Positive news for sure, but how does one weigh that against a budget deficit that widened from $158 billion last year to the $455 billion expected this year - which quickly led to the recent record $60 billion issuance of Treasury notes to help fund some of the deficit. Using the above supply/demand formula in reverse - this recent issuance puts downward pressure on prices and upward pressure on yields.

Hopefully the current interest rate environment will settle down, but I feel its imperative as an organization to keep our clients apprised of what's happening in the capital markets. We've seen a number of "fence sitters" respond by locking in rates and eliminating further interest rate risk for their projects.

Peter Slaugh

Editor of the "From the Street" newsletter, Chief Executive Officer Peter Slaugh founded Steelhead Capital in 1999. In the relatively short period since its inception, Slaugh has built Steelhead into a leading resource for debt and equity placement nationwide. Slaugh is primarily engaged in growing the company and its lender relationships, as well as working on financings. Email Peter

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