It remains very unclear where rates may move over the next few months. The Fed and Dodd Frank have created a dangerous and rapidly developing liquidity crunch in the Treasury and bond markets. The Fed swept up $4 trillion of various bonds, and Dodd Frank regulations on the major banks trading desks and capital requirements has caused them to shed as much as 90% of the bond inventories. Due to the regs, once bond prices begin to move even lower than they recently have, the banks will be loathe to hold bonds and have these losses reflect on their capital and risk parameters. So Dodd Frank has managed to severely curtail the trading market to the extent that it is not really a market price for bonds that we see today. Not only is there very limited liquidity for large holders, but price moves are accentuated by the lack of liquidity.
The real problem will come when rates continue to rise even more than in the past few weeks and there is a flood of bonds hitting the market all at once. There will be few buyers thereby pushing bids down at an accelerating rate. There is a risk that the downward rush will be pushed further than a true market would have pushed them and rates will move up very fast. Then we need to look at the fact that the Fed has to dump several trillion of bonds on this limited market over the next few years. At some point the ECB will also need to dump all of the bonds it is now buying. Other central banks around the world will be doing the same. One assumes the Fed and ECB will be careful in their liquidation programs, but there will be this massive overhang to the market for years to come. Once the liquidation starts in earnest the overhang becomes real.
So what does all this portend for CRE. It is very likely that rates will rise from here on with only the speed of the rise and extent in a given period to be yet determined. We saw what happened to the Bund in a few days where it shot to a higher rate in days. The ten year has moved up in rate 50 basis points rather quickly, and it could see other volatile jumps over the next year which will then get exaggerated by the liquidity crunch. And all of that is before the fed begins its liquidation program.
If you are currently borrowing floating, and you intend to hold the asset for several more years, you could potentially suddenly find yourself in a serious cash flow problem. There is no perfect hedge, so if you think you have a cap and are hedged, you may only be partially covered. You should get an independent source like Chatham to look at your positions and assess your true risk. Don't ask you lender. They have a potential conflict since they likely sold you the cap or hedge.
Nobody can accurately predict where rates and thereby cap rates will be at any future date and trying to predict is almost always fraught with error. However it is essential that you understand that there are forces building up with the lack of liquidity and the flood of sales of bonds eventually from the Fed and central banks that will not be a favorable impact on rates. Make sure you are in fixed loans now or that you have a true expert assess your real risk and find ways to mitigate what is surely coming sooner than you may expect.
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