Fed Cuts and the Bond Market Fake Out

Real estate investors have been eagerly waiting for the fed easing cycle for what seems like eons now. The tightening cycle began on March 16, 2022 and would start the most aggressive rate hiking cycle not seen since the 1970’s. This caught many real estate investors off-guard. Those most affective were investors who closed deals with variable rate financing. Why were they doing that?

In the years leading up to 2022, fixed rate loan debt was becoming a non-option due to the higher rates and prepayment penalties. Investors turned to variable rate loans to make deals work. Those rates were lower, had no prepayment penalties and made the deals cash flow better than they would if they had fixed rate debt. Not a bad gambit if you

could exit your deal before your rate increases. In fact, for many, the variable rate loans worked well. Inflation was tame, and historically long term bond yield had been decreasing for decades. Risk was mitigated by buying an insurance product called a rate cap.

All this changed when in February 2022. The CPI data registered a year over year inflation reading of 7.9%. Since then, investors who were poorly capitalized started taking heat. And since then, investors have been eager for the day the Fed would reverse the hiking cycle.

Well, that day has come and after a 50bps rate cut, the results are not what investors expected. Borrowing rates actually increased as a result. The bond market did a massive and unexpected fake out of the financial markets. Why? Simply put, the bond market did not agree with the Fed that inflation was under control. Bond investors sold into the news and rates have been climbing for 4 weeks straight.

This hammers home a very important lesson for investors. The trajectory of borrowing costs is determined more by the rate of change in inflation expectations and not always due to the actions of the Fed. The Fed after all controls the borrowing rate for short term rates. Mortgage rates key off of the 10-year yield which is determined by the market. Until inflation comes reasonably under control, the relief investors are seeking will continue to remain elusive.

Next Wednesday we will get another CPI reading and its likely to show a move higher from the low September print. Though we've seen a small pullback in the 10 year over the past few days, the volatility is not going away.