Expect the unexpected?

Expect the Unexpected?

October 5, 2023

In 2023, expectations were set for a sequence of events: a potential recession, interest rate cuts, and a return to what might be considered normal or even lower interest rates. However, as the fourth quarter unfolds, we face circumstances quite the opposite of these initial projections. This reality raises a fundamental question: How prepared are we to anticipate the unexpected?

Who could have foreseen that by the fourth quarter, we would witness circumstances nearly opposite to initial expectations? Contrary to predictions, we have not encountered a recession or rate cuts. Remarkably, the 10-year U.S. Treasury yields have surged by 54 basis points within only 20 trading days. To be honest, I wanted to make the title of this newsletter, “Reasons to Hope the FED Raises a Few More Times, and Why I Believe Long-term Paper is Extremely Well Priced Right Here,” but that sounded a little wordy and lacked a spark.

I can hear the critics saying both those ideas are ridiculous things to hope for, but just hear me out. Most people are familiar with inflation, experiencing it daily in their consumption of goods and services. When managed effectively, inflation can stimulate economic growth by increasing asset values, encouraging speculation, and spurring business investments. It can also tilt the balance towards spending over saving, further boosting economic activity. However, it’s essential to acknowledge that inflation can disproportionately penalize those without hard assets to borrow against, allowing those with hard assets to inflate away their debt. It also introduces uncertainty into consumer and business decisions, which must account for current inflation and estimate future inflation expectations.

The more extended inflation persists, the more it ingrains uncertainty into our economic outlook. Numerous studies reveal a correlation between prolonged high inflation and consumers and businesses perceiving inflation as higher than it is. In short, the longer inflation lingers, the more it heightens our expectations of inflation, even if actual inflation remains lower. This is precisely why I argue that the Federal Reserve should consider raising rates a few more times. The primary battle now is against the perception of inflation rather than its reality. They must work to quell inflation concerns to the point where it is no longer a frequent topic of discussion at the dinner table but rather just a monthly figure reported in the latter pages of the Wall Street Journal. Until this perception is achieved, the Fed’s job remains incomplete. There will be collateral damage, such as a few banks, with First Republic Bank (FRB) and Silicon Valley Bank (SVB) coming to mind, and numerous overleveraged properties heading into default and foreclosure. However, the consequences of not addressing inflation perception could be far more severe.

The reason I advocate for locking in 10-year fixed-rate debt at this juncture. The rationale is straightforward: I doubt whether politicians, including the Federal Reserve, possess the conviction or capability, should adverse events occur, to see their plan through to the 2% inflation target. The Federal Reserve currently lacks control over long-term bonds. A prime example is—the last time they raised rates by 25 basis points, and the 10-year U.S. Treasury yield surged by 150 basis points. The market is now taking the reins, and with the four largest buyers of U.S. Treasuries sidelined – the Federal Reserve selling through Quantitative Tightening (QT), China abstaining from purchases, Japan forced to sell to defend its currency, and U.S. banks refraining from buying – one must question the Federal Reserve’s ability to intervene should issues arise before they successfully lower inflation back to the 2% target. Quantitative Easing (QE) would be inflationary, and fiscal policy in Washington, D.C., appears to be in disarray under both political parties. Hence, the most potent policy tool at their disposal is the ability to adjust short-term rates. It is no surprise that 10-year U.S. Treasury yields are on the rise. Uncertainty has swelled over the past year, reaching levels not seen since the GFC.

To digress briefly, I argued in this newsletter about 18 months ago, discussing defeasance (you can read it here: 3 Reasons I’m Paying The Defeasance Penalty), that valuations would likely never be this high and could only trend downward. Consequently, paying the defeasance penalty, locking in a lower rate, and eliminating uncertainty from your investment equation made sense. Fast forward 18 months to today, and this argument appears prescient. However, there’s another layer to this discussion now. While values have decreased, the realization of lower values in most markets has yet to materialize because transaction volumes have declined by over 50%, depending on which investment sales firm you consult. This is advantageous for those in need of refinancing. Even more favorable, recent biases have anchored mental cap rates considerably lower than what actual cap rates should be. This is excellent news for those seeking refinancing opportunities right now. The reason behind the significant decline in the sales market is straightforward: market-clearing cap rates currently sit 100 to 300 basis points higher than what sellers believe them to be. However, here comes a caveat: as the 10-year U.S. Treasury yield continues to climb, market clearing cap rates will have to adjust upward, affecting valuations across the board as loans come due in the coming years. The extent to which rates may rise is a matter of debate, but I recently spoke to a fixed-income trader who posited that the real fireworks might occur at the longest end of the yield curve, the 30-year, which does not bode well for the housing market, though the 10-year will not be immune either.

This brings us back to the fundamental question: “Expect the Unexpected?” Speaking for myself, I would answer “no.” However, considering the current uncertainty in the world and financial markets, it’s prudent to contemplate this question more seriously. One practical approach to mitigate uncertainty, which I am personally adopting, is to lock in a 10-year paper. My reasoning is simple: take the capital markets risk off the table and focus on operations and cash flow for a while.

The good news in all of this is that with great uncertainty comes great opportunities.

John Darrow
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