On July 26th, the Federal Reserve System (the Fed) announced they will maintain the current target range for the federal funds rate, 1.00% – 1.25%. The Fed also reaffirmed their promise from their June meeting and will “begin implementing its balance sheet normalization program relatively soon.” There are many eyes on this balance sheet because of the far reaching effects of unwinding $4.5 trillion worth of securities.
The Fed has gotten to this enormous balance sheet by purchasing primarily Treasury and mortgage-related securities, which represent approximately $2.5 trillion and $1.8 trillion respectively. These purchases began in 2008 as a way to stabilize the financial system and promote economic recovery following the “Great Recession.” The high demand from the Fed would ensure the bond prices stayed high and thus interest rates low. The Fed expressed an intention to raise the federal funds rate to return to normal before unwinding the balance sheet. This is to ensure interest rates are above their lower bounds, leaving the Fed room to handle effects of reducing their balance sheet.
A rising federal funds rate and falling balance sheet will have an effect on the net lease market. A higher federal funds rate can be expected to push interest rates higher, meaning the cost of borrowing money will become more expensive. The Fed’s plan for reducing their balance sheet by “decreasing its reinvestment of the principal payments it receives from securities held in the System Open Market Account.” With the Fed buying fewer Treasuries, this lowers the overall demand for government bonds, which means they will fetch a lower price at auction. This lower price translates to a higher interest rate, higher returns on investment, and more attractive government securities. These higher returns on investment for “risk-free” securities will push other forms of investment to find ways, such as lower prices and/or higher returns on investment, to stay competitive.
The net lease market will be affected on two fronts. The rising federal funds rate will increase interest rates for investors looking to use debt to acquire properties. The unwinding of the Fed’s balance sheet will lower demand and therefore prices on government securities causing other investments to fall in price as they strive to remain competitive, pushing cap rates higher. The timing of these changes will be determined by the market in conjunction with the Federal Reserve.