Will property yields rise under the new Federal Reserve Board Chair?
June 8, 2018 / By Dr. Char Leung
The new chair of the US Fed, Jerome Powell, has indicated a preference for explicit rules as a basis for setting policy. Specifically, Powell attaches importance to the Taylor Rule[1], which would dictate the Fed to set its policy rate against inflation and the pace of economic growth. What does this mean for property yields?
An increase in the overnight US Fed Funds rate can also affect the yields on US Treasury bonds issued, influencing long-term interest rates. Long-term rates influence property yields because property is a long-term investment. Moreover, a rise in the US Treasury yields may affect government bond yields in other countries. In particular, studies have shown that the spillovers effects tend to be stronger in emerging markets than in advanced economies[2]. As a result, property yields may potentially adjust in tandem with government bond yields, depending on the spread between property yields and sovereign bond rates. This chain reaction has previously been addressed in JLL’s paper “How will interest rate movements affect prime office yields in Asia Pacific?”.
Chart 1: How Fed Funds rate affects property yields
Source: JLL
If US monetary policy follows the Taylor Rule, the Fed should have already raised the policy interest rate to about 4%, far above the current level of 1.75%. So does this mean that property yields are also set to rise?
Chart 2: Taylor rule as a rule of thumb in monetary policy making
Source: Federal Reserve System, JLL
The answer lies partly in the connection between the short-term policy rate and long-term bond yields. While a Fed Funds rate hike drives up short-term bond yields, long-term bond yields and property yields may behave differently. On one hand, the long-term and short-term bond yields might co-move to rule out arbitrage opportunities. On the other hand, a rise in the Fed Funds rate might be a signal that inflation or economic growth is about to fall, hence supporting lower long-term bond yields, and thus also property yields, as the economy cools.
It has been shown that different motives behind setting monetary policy can lead to different outcomes in the bond market[3] which may further affect property yields. If the rise in the Fed Funds stems from evidence that the US economy is strengthening, the result will be a rise in both the short- and long-term bond yields to a level consistent with expected economic conditions. In contrast, if the rise in the Fed Funds rate reflects a policy shift to fight inflation, the result may be a decline in the long-term bond yield and downward pressure on property yields.
Finally, adherence to a Taylor-type policy rule will make US monetary policy more predictable. Financial and property markets always apply a discount to uncertainty. Greater predictability means less risk, therefore a narrower spread between property and government bond yields. Powell’s preference for rule-based policy settings may lead investors to expect that future inflation will be contained, placing limited upward pressure on bond yields. As a result property yields should remain largely stable in the foreseeable future.
[1] Taylor, J.B. (1993) “Discrete versus Policy Rules in Practice”, Carnegie-Rochester Conference Series on Public Policy, 39, pp. 195-214.
[2] Gupta, P.; Masetti, O. and Rosenblatt, D. (2017) “Should emerging markets worry about U.S. monetary policy announcements?”, Policy Research Working Paper Series 8100, The World Bank.
[3] Ellingsen, T. and Söderström, U. (2001) “Monetary policy and market interest rate”, American Economic Review, 91(5), pp. 1594-1607.
