Euro Crisis, Fed Accomodation, and Underassessed Risks to CRE

The Bank for International Settlements released its annual report yesterday, enumerating a litany of concerns about the global economic outlook. Reflecting on the most recent deceleration, the BIS wrote “the economic momentum in advanced economies [has been] too weak to generate a robust, self-sustaining recovery.”

Among the advanced economies, Europe is in the most challenging position. Although recession has not been declared formally, the evidence of contraction is clear enough. European leaders will meet beginning this Thursday in Brussels and are expected to grapple over stimulus measures. The anchor economies remain at odds over how to proceed, with Germany appearing increasingly isolated in its resistance to more flexible crisis-response measures. If France and Italy do not persuade Germany, the perceived failure of the summit may trigger a new wave of volatility in financial markets.

Navigating the recovery’s domestic fault lines, the Federal Reserve committed last week to continuing the maturity extension program otherwise set to expire at the end of June.  Over the next six months, the Fed will adjust the composition of its balance sheet, exchanging $267 billion in short-term securities for longer-term bonds.

In part because Treasury yields are already at their historic lows, it is unclear if the Fed’s renewed commitment will be impactful. Commercial real estate investors should not expect their borrowing costs to fall as a result of the program, though a worsening crisis in Europe could see benchmark rates find a new rock bottom.

At implausibly low levels for a protracted period, borrowing costs for well-qualified investors are contributing to improving property prices in segments of the market where the real economy and fundamentals cannot. But lenders and their borrowers must take a long view as they assume greater interest rate risks. This source of support will fall away once rates rise, fomenting asset price volatility in proportion to our current dependence on cheap money.

Financial and macro economists are mindful of the risks that may be less apparent on the ground. The BIS' warning is instructive in this regard: ... low short- and long-term interest rates may create risks of renewed excessive risk-taking. Countering widespread risk aversion was one important motivation for the exceptional monetary accommodation provided by central banks in response to the global financial crisis. However, low interest rates can over time foster the build-up of financial vulnerabilities by triggering a search for yield in unwelcome segments ...