Interest Rates are NOT Going Back Down in 2023

[Scott Trench]

Responses to a recent poll indicated a sentiment among the BP audience that suggests that members of this forum believe that rates are going to decline over the course of 2023. 

I do not believe this, and want to make it clear that I think it is extremely unlikely and optimistic thinking that interest rates - specifically the interest rates on mortgages and commercial real estate debt - come down in 2023. If anything, they are going up. 

Here's my argument (and yes, I am aware that this makes me a bear on real estate prices in 2023 - I believe that prices for residential real estate - 1-4 unit property - will decrease 5-10%, in line with Dave Meyer's projections. I believe that prices for commercial real estate are at risk of "crashing" by more than 20%): 

1) Fed Guidance: The Fed says that they are going to raise rates to 5.0 - 5.25. I think it is a mistake to disregard their forecasts. Yes, they were full of it in late 2021, but Jay Powell is not kidding this time around - he intends to do what he says. The Fed are not here to BS us. Their goal is to have as little disruption to the economy as possible while maintaining their inflation target. And as crazy as 2021 was, they are the "least bad" central bank in the world at what they do. 

2) Wage Inflation Remains Strong: Inflation is not yet beaten and the Fed will not stop raising rates or consider decreasing them until it is. Wage Growth is the Fed's lead indicator. Housing prices, oil, and other items that impact the CPI are watched, but are ultimately noise to the Fed, and reasonably so. Oil prices boom and bust. Raising rates increases housing costs, because mortgages get more expensive. The Fed is fighting wage inflation. And wage inflation is still really strong. The Fed has an uphill battle here. 10,000 Boomers are retiring every day and there are not enough immigrants and Gen Zers entering the workforce to replace them. This demographic challenge will continue for decades. 

3) The Fed has more room to fight inflation without worrying about unemployment than in the last 100 years: The Fed has a dual mandate - keep inflation low, and keep employment strong. This balancing act forces tradeoffs, sometimes, that are difficult to reconcile. The Fed doesn't have to worry about that today, however. The real minimum wage is lower today than at any time since the 1940s (I actually think there shouldn't be a minimum wage at all, but that's a topic for another day). When a bunch of rich tech workers get laid off, it makes headlines, but preventing these folks going from earning $200,000 per year to $175,000 isn't exactly the Fed's charter. Those folks will likely by and large find jobs right away and the economy will go on. Furthermore, as I mentioned above, if anything, wage growth is still incredibly strong for the median American. As much pressure as interest rates put on wage growth, the demand for a shrinking pool of talent is still there. The Fed has multiple years of pushing before unemployment balloons in this country. 

4) Pundits forecasting mortgage rates declining fundamentally don't understand the debt markets: The basis of most pundit forecasts for mortgage rates coming down in 2023 is that the spread between the 10-year treasury and current rates is very high - about 300 bps, vs an average of 180 bps. Thus, the pundit argues, mortgage rates will come down 100-120 bps as that normalizes to the historical average. 

I agree that the spread will normalize by the end of this year. But it will not normalize because mortgage rates will come down. It will normalize because the 10-year treasury yiel will rise dramatically. This time last year, the 10-year was at 2.05% vs .02% for the 1 month US treasury. Right now, the 10Y is at 3.8% vs a 1-Month rate of 4.64%.

Unless the economy declines rapidly from it's current state, the Fed is going to continue to INCREASE rates by another 100 bps this year. That puts the 1 Month Treasury at 5.5%. Add another 2% (a "normal" spread between the 10-year and the 1-month), and that gets you a 10-year yield of 7.5%!!? That's up nearly 400 bps from where we are today. Do I think that the 10-year will get THAT high? No. Do I think that the 10-year will increase dramatically? Yes I do. And so will mortgage rates for all products backed by government sponsored entities like Freddie and Fannie. 

Rates are going UP, not down, in 2023. 

Common counterarguments: 

"But the Deficit and US Debt!?" - This is a fun one. First, the Federal Reserve is not, NOT, NOT, on team Federal government. Jay Powell isn't loved by republicans. He isn't loved by Democrats. His term doesn't expire until 2026. He will preserve his legacy and the Fed's charter. Not bail out the Federal Government - unless that aligns with his charter. The fact that interest rates are rising will put pressure on the Federal government, but not to the tune of decreasing rates. If anything, the opposite is true. If higher rates put pressure on the Federal government to service it's debt, that will decrease investor confidence, and... the 10-year will increase (and along with it, mortgage rates, etc.). 

"But What About a Recession or Depression?" - I actually agree with this counterargument. If there is a much deeper recession than the current economic climate (I agree that this will be called a recession in future years by EVERYONE), then yes, the Fed will reduce rates. But, think about the implication of this counterargument. 

Either, rates will increase because the yield curve will normalize. OR, we have a very deep and horrible deflationary recession where millions of Americans lose their jobs. 

If you are betting that interest rates come down, you are betting on a macroeconomic disaster. Let that sink in. Just to make myself louder so that the people in the back can hear me - if you are betting that interest rates come down in 2023, you are betting on a major deflationary event. 

I won't argue that you are wrong. It could happen. It's just not my bet. I'm betting on an "unpleasant" year for the economy, but not one that is so memorable that it will be talked about for the next several decades like the Great Financial Crisis. I'm betting that the Fed get's their "soft landing". But, if you are going to make the bet that interest rates are going to come down in 2023, understand what you are betting on. You are making a bet that the economy is going to collapse so badly that the Fed has to knee-jerk react and reduce rates rapidly. I, for one, do not think that if this comes to pass, that many real estate investors will be refinancing their properties at the ARV that they anticipate.

Understand your bet. 

There is one scenario where interest rates come down slightly and prices continue to climb in year 2023: Continued uncertainty/fear. If the markets can sustain a sense of uncertainty and fear for the entire year, without us actually seeing asset values decline, or mass unemployment, the yield curve could stay inverted for all of the next 12 months, and the spread with mortgage rates could normalize. While that is possible, I believe that this bet is the equivalent of balancing a knife with the economy for the entire year. With incredible precision from the Fed, it is possible. But, I would be very uncomfortable with this as a shor-term bet. 

What I'm doing with my money: 

- I continue to maintain strong personal finance fundamentals. I spend less than I earn. I maintain an emergency reserve of 6-12 months spending. This, frankly, held me back for the past 8 years. I could have been much more aggressive and been much farther ahead. I don't regret it though, and believe that liquidity is a big savior for folks when pressure mounts.

- I am holding onto properties I had previously purchased and let the low interest rate debt on these properties amortize. I've taken a hit to their values in the last 12 months, but there's no sense in liquidating cash flowing properties with great low-interest rate debt.

- I am rebalancing my securities portfolio from 100% stocks, to 50% stocks, 50% debt. This is not primarily out of fear (although I have a healthy amount of fear), but simply because there are so many opportunities to lend at 7%+ interest rates. If you believe the long-term average returns of a stock market index fund are likely to be 7-10%, and mortgage rates for people with Excellent credit are 7%+, then it makes sense to lend. Personally, I like short-term debt (because rising rates also hurts the value of long-term debt portfolios). 

- I'm considering purchasing new properties all in cash - perhaps with partners. Interest rates are higher than cap rates. So, in addition to being the lender, why not just buy without debt - lower risk, and higher returns, unless prices appreciate considerably. 

- I believe, also, that this is the year for Pace Morby and creative financing. I think that creative financing is a great option in today's environment, and that already there are tons of opportunities to use this tool, opportunities that are only going to increase in abundance throughout the year as sellers i more markets get comfortable with structuring debt this way.

[Jevon Shaw]

Solid and very informative argument! One thing that I think most of us can agree on: This is a great economic environment to learn a creative financing strategy.