From the looming “fiscal cliff” in the United States to the continued debate over growth versus austerity abroad, economic risks continue to drive overall interest rates. Domestically, the Federal Reserve Board (the Fed) actively communicates with market participants its intentions to use available tools at its disposal, including the targeting of short-term rates via federal funds and the purchase of long-term debt in an effort to push long-term rates down thereby stimulating economic growth. In an effort to confirm its dual mandate established in the 1970s of addressing inflation and maintaining employment, the Fed recently announced its desire to target a specific unemployment rate (6.5%) as an indicator for further monetary stimulus. This is tied to a desire to keep inflation at less than 2.5%. Future Fed stimulus then will focus specifically on these two disparate data points.
However, the U.S. economy remains mired in a period of little or no growth, showing few signs of breaking out. While global equity markets have shown unanticipated resilience, news from developed markets, especially the eurozone, continues to be downbeat as the fallout from recently adopted austerity measures has yet to be exhibited. The lone bright spot internationally continues to be China, but less so than in years past. This area of the globe is also struggling through an economic downturn, but unlike the United States, China has room to reduce interest rates in an effort to stimulate growth.
The Fed maintains an aggressive policy of low short-term rates, i.e., the target federal funds rate, while implementing a number of unusual monetary policies since 2008, which it described as “extraordinary measures.” These included two rounds of bond purchases, characterized as quantitative easing (QE1 and QE2), with a round of mortgage-backed securities purchases sandwiched in between. In an effort to push long-term interest rates down, the Fed sold short-term securities in its portfolio using the proceeds to purchase long-term securities, as it extended the average maturity of its bond portfolio in a program called Operation Twist, which is set to expire at the end of 2012. (See Figure 1.) On Dec. 12, 2012, the Fed stated that it would continue quantative easing (QE3 and QE4) by purchasing bonds, both Treasuries and mortgage-backed securities (MBS), at the rate of $85 billion a month.
The current goal of the Federal Open Market Committee is to lower longer term interest rates even further in hopes of avoiding deflation, reducing the unemployment rate and ultimately spurring a recovery in the U.S. economy. Longer term interest rates have declined slightly, with the 10-yr UST falling from 1.9% at the end of 2011 to about 1.6% currently, as shorter term rates also fell, with the three-month London Interbank Offered Rate (LIBOR) falling to 0.31%.
Risk Factors and the Interest Rate Outlook
The median forecast in the Nov. 15, 2012 Bloomberg survey of economists calls for LIBOR to remain relatively stable in 2013. It is not expected that the Fed’s latest announcement will cause this forecast to change. Meanwhile, longer term rates are forecast to rise modestly from the current 1.6% to approximately 2.2%. Interestingly, the same survey of a year ago provided similar short-term forecasts, while suggesting that the 10-yr UST would rise to 2.36% by the end of 2012.
There continues to be a great deal of uncertainty throughout global markets, contributing to uncertainty about the future path of rates in the United States. Although there are many factors that will impact U.S. rates in 2013, the following represent the most compelling:
- Fiscal Cliff?The concurrent introduction of budget cuts and increased taxes may result in economic distress, at least in the short run. If Congress does not act and the nation is unable to avoid the full impact of the fiscal cliff, it is unclear how interest rates might respond. Some believe that they would move lower due to the possible recession; however, others believe they could rise due to investors’ concern about the inability of the United States to deal with its fiscal challenges.
- U.S. Economic Growth?By tying the interest-rate outlook to unemployment and inflation, the Federal Reserve will respond to a significant improvement in the U.S. economy with an increase to the target federal funds rate. This is unlikely, however, as the outlook for 2013 includes slower than average gross domestic product (GDP) growth and only a modest decline in the still high unemployment rate. Fed officials don’t anticipate the jobless rate falling to the goal of 6.5% until 2015.
- Inflation?In spite of increased volatility of energy prices, inflationary pressures remain subdued. Should inflation increase beyond an acceptable level, however, the Fed will likely change its accommodative stance and begin to raise short-term interest rates or begin to modify its message to market participants of a change in policy due to changing market risks, which will have a similar effect.
- Additional Fed Actions?Given the stubbornly slow economic recovery in the United States, the Fed could take additional measures to spur economic growth, including additional purchases of federal debt. It is unclear if this would impact LIBOR or the 10-yr UST yield because many believe another round of quantitative easing should focus primarily, if not exclusively, on residential mortgage-backed securities (RMBS) in order to more directly benefit the U.S. housing market.
- The Euro Crisis?As much of southern Europe continues to struggle with large amounts of government debt and record unemployment, economic contraction has begun to spill over into neighboring regions. As a result, many investors are fearful of potential credit losses, causing them to sell European government bonds and buy U.S. Treasury securities due to their perceived safe haven status. Therefore, a continuation of the Euro crisis could support demand for U.S. Treasury securities, thereby helping yields to remain low throughout 2013.
Given that U.S. interest rates are near all-time lows, it is difficult to assign a high probability of them moving appreciably lower in 2013. Conversely, the current issues facing global markets, as discussed above, make it unlikely that interest rates should move significantly higher over the coming year. Although rates could experience some short-term volatility, moving slightly higher on good U.S. economic news or slightly lower on fresh bad news related to the current budget impasse relative to the “fiscal cliff” or the euro crisis, U.S. interest rates should finish 2013 not far from where they begin the year.
Available Funding Options
So, what does this all mean for borrowers operating within the health care and housing sectors?
For health care, the economic slowdown of the past several years has placed great strain on federal and state governments, forcing cuts to many programs, including Medicare and Medicaid. Future demands will continue to place considerable pressure on these programs. “Bending the cost curve,” the phrase popularized by recent health care reform debates, will be a fact of life going forward and only those providers who are able to efficiently provide quality care will realize the risk-based returns that are necessary to properly reward ownership.
The historically low rate environment provides a unique opportunity for borrowers to improve cash flow now while enhancing the competitive positioning of their organizations for years to come. Interest costs represent a considerable cash outflow of most providers, yet one that is not easily controlled by management. Providers must look to capture the opportunity when favorable economic conditions are present.
In general, with both short-term (LIBOR) and longer term (10-yr UST) rates forecasted to remain historically low into 2013, several strategies are available that could provide good results. Short-term LIBOR-based variable rate loans will likely continue to provide some of the lowest borrowing costs available, albeit at some risk to rising interest rates. LIBOR-based loans from commercial banks or finance companies are becoming more widely available as the “credit freeze” continues to thaw. Further, LIBOR-based variable rate programs offered by Fannie Mae and Freddie Mac offer access to short-term variable rates. In particular, Fannie Mae’s new ARM 7-6 program provides an exceptional combination of low current interest rates, flexible pre-payment provisions, and an imbedded interest rate “cap” to protect against a considerable rise in rates. The program could be used as a bridge or intermediate term (up to seven years) financing option for refinance, equity “take-out,” or moderate property improvements.
Of course, those wanting to capture the historically low rates on a longer term basis are turning to the HUD/FHA finance programs, which have provided record loan volume over the past two years. With up to 35-year terms, it is the ultimate vehicle for those seeking truly permanent financing, and with the program’s loan assumption features, may actually create incremental property value in higher rate environments that are likely to exist further into the future. With demand for the program so high, application time frames may take longer; however, with expectations that rates will remain low for some time, borrowers should be able to achieve a historically low rate despite the wait.
William M. Courson is the president of Lancaster Pollard Investment Advisory Group in Columbus. He may be reached at firstname.lastname@example.org.
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