At the end of June 2014, Jaime Caruana said out loud what many are secretly fearing: the low level of interest rates on global capital markets is “not normal” and, for that very reason, will not last much longer. Consequently, he emphatically warned investors against growing accustomed to cheap money in the long run and disregarding possible risks in their pursuit of returns. He also urged central banks not to wait indefinitely before abandoning their loose monetary policy and to start tightening the interestrate screws in the foreseeable future. Jaime Caruana is not just anybody: a former governor of Spain’s central bank, he has been General Manager of the Bank for international Settlements (BIS) in Basel for more than five years. This financial institution, founded in 1930, is seen as the central banks’ central bank: this is where central bank governors from all over the world deliberate on monetary and financial-market stability, and where parts of the BIS members’ currency reserves are managed. It is also home to the Basel Committee on Banking Supervision, whose Basel iii rules, in force since 2013, regulate the activities of financial institutions worldwide.
This appeal from the BIS chief to his colleagues in the central bankers’ guild gives fresh impetus to a discussion that has exercised the capital markets for months: investors around the globe are wondering when interest rates will begin to rise – for it seems certain that this will happen. Back in March 2014, when she became the new chair of the powerful US Federal Reserve (fed), whose decisions are crucial for global capital markets, Janet Yellen announced an end to the USA’s ultra-loose monetary policy. Also, a majority of her colleagues at the fed signalled that the first interest rate rises in the USA could come in 2015. Readers will recall that the fed has held its key interest rate at a historical low of nearly 0 percent since the financial crisis began in 2008. That is not all: the central bank has been buying government bonds and mortgage-backed securities on a huge scale and thus pumping trillions of dollars into the financial systemT the aim is to use this fresh money to boost the country’s economy and help the languishing labour market to recover. This programme seems to be working. Although the US economy shrank significantly in the first quarter of 2014 because of the harsh winter, an international Monetary fund (IMF) projection suggests that, in 2014 as a whole, it will grow by 2 percent; and the economists actually predict a rise of 3 percent for the following year. Even more positive signs are coming from the labour market: the US unemployment rate fell to 6.1 percent at the end of June 2014.
At the height of the recession in early 2010, 10 percent of Americans were jobless. The IMF expects the situation to ease further and the rate to drop below the 6-percent mark in 2015. The patient’s condition is clearly improving. For this reason, the fed is gradually reducing the dosage of its revitalising financial injectionsF Originally, these came to $85 billion per month, and in July 2014 the invalid was still being given $35 billion. If the patient’s recovery continues at the same pace, by October he will be fit enough to do without this stimulant from the bank’s printing presses completely. The logical next step on the road back to monetary normality would be to raise key interest rates. However, the fed’s members are meeting this very question with responses that are not merely vague, but even contradictory. For instance, in an interview at the end of June 2014, US central banker James Bullard suggested that interest rates could start to rise in the first quarter of 2015, always providing the economy continued on its growth trajectory. This promptly sent stock exchanges into a nosedive. Both the US Dow Jones index and Germany’s Dax suffered losses. The reason is that stock exchanges are allergic to rising interest rates, because they result in investors switching from shares into bonds and thus putting share prices under pressure.
Just a few days later, the supreme custodian of US monetary policy, Janet Yellen, spoke up again. Like Jaime Caruana, she expressed concern at the increasing willingness of international investors to take risks in pursuit of higher returns. However, she described an early turn-around in interest rates to counter it as too “blunt [an] instrument”. It would cost jobs, and she therefore saw it only as a “last resort”. So, does this mean there is no likelihood of an early interest rate rise in the USA? And what is the view of the European Central Bank (ECB), as the second major issuing bank, on ending the cheap-money policy? National central bankers find themselves on the horns of a dilemma. If they raise key interest rates, this will initially affect only short-term rates. However, long-term rates would soon follow. This would hit countries themselves, as it would make it more expensive for them to raise money on the capital markets. This would hurt not only the USA but also, and especially, the nations of southern Europe.
Real estate cycles collapse not because of rising interest rates, but because of oversupply.
For this reason, ECB President Mario Draghi is likely to allow more, not less, time to pass before raising interest rates than his fed counterpart Yellen, especially as the eurozone inflation rate in June, at 0.5 percent, was below the 1-percent mark for the ninth month in a row. What is more, the head of Europe’s central bank very recently did not merely cut the key interest rate to a record low of 0.15 percent, but also imposed a penalty interest charge on banks for parking money at the ECB. This is intended to encourage financial institutions to make more loans available to companies. The ECB programme for long-term lending, which was spelt out in July 2014, has the same aim: banks will receive these loans for a four-year term at an interest rate of close to 0 percent on condition that they do not reduce their lending business. The ECB is going to make a total of €1 trillion available for this. As a result, many observers doubt whether central banks will pay any heed to BIS chief Jaime Caruana’s words of warning. Stefan Schilbe, Chief Economist at the bank HSBC Trinkaus & Burkhardt, for one, does not expect to see a “sustained turnaround in interest rates” before 2017.
Property investors, however, will take Caruana’s warning seriously. This is because monetary policy decisions by central banks also have a major impact on them, albeit not in the way that many expect. “The causal chain suggesting that rising interest rates make property investment unattractive may appear logical, but it is wrong in reality”, says David Milleker, Chief Economist at Union investment. On the contrary, economic conditions, interest rates and property yields usually move in lockstep, the economist notes, citing the office property market as an example: although interest rates do rise during an economic upturn, the same applies to rents, because expanding companies are looking for more space. As a result, real estate income goes up, and with it so do rental returns. This, in turn, gives a boost to construction activity, and as long as project developers keep a close eye on economic risks, there are no grounds for concern. The situation becomes precarious only if more buildings are put up than the market can sustain.“ In other words, real estate cycles collapse not because of rising interest rates, but because of oversupply”, Milleker says, getting to the heart of the matter.
Similarly, Tobias Just, Professor and Academic Director of the IREBS international real Estate Business School at the University of Regensburg, sees no reason to take a negative view of a turnaround in interest rates in relation to European property investors – “even if this may seem surprising at first glance”. His view is that an early turnaround in interest rates in the USA is likely to lead to a relative weakening of the euro. However, he believes, a strong dollar, taken together with improved US growth prospects, is good news from the point of view of European investors – “at least, as long as you invested before the change in the exchange rate and did not wait until after interest rates began to rise. ”Therefore, there are a number of reasons to believe that European property investors need not fear rising interest rates. On the contrary, in the words of Union investment Chief Economist David Milleker: “Rising interest rates, as a consequence of economic normalisation, are actually something to be welcomed.”