In a much-anticipated move, the Federal Open Market Committee (FOMC) announced a rate hike of 25 basis points (bps) on July 26. This aligns with the FOMC’s plan, as expressed by Chairman Jerome Powell, to bring inflation down to the central bank’s 2% target. In the meeting, the FOMC also unanimously agreed to make data-driven decisions.
This thorough assessment of the impact of rate hikes aligns with the FOMC’s emphasis on assessing “the totality of the incoming data.” Such a prudent approach makes sense, given that changes in interest rates typically take around 12 months to impact the economy fully.
As demonstrated in Table 1, it is evident that the FOMC’s initiation of interest rate hikes on March 17, 2022, resulted in a delayed but discernible impact on the Consumer Price Index (CPI) and Personal Consumption Index (PCE). These indices only began to show signs of peaking in June 2022, indicating a delay before the effects of the initial interest rate hikes took hold.
The most significant consequences of the rate hike were seen in March this year, precisely 12 months after the first rate increase. Moreover, the effects became even more pronounced in the CPI data for May and June this year, providing further evidence of the lagged effects resulting from the series of interest rate hikes.
US retail sales, a vital gauge of consumer spending and a significant driver of overall economic activity, also demonstrate this trend. As depicted on the right side of the table, the initial interest rate hike on March 17, 2022, caused a sudden, front-run reaction leading to a y-o-y drop of 59.6% for March 2022. Another notable decline of 58.8% did not occur until March 2023, exactly one year after the first rate hike.
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While rate hikes can effectively combat inflation, they can also create a dual scenario, particularly within the housing market, potentially signalling a slowdown in economic growth or recession. This effect is apparent in the US House Price Index’s y-o-y change.
The index showed a significant growth slowdown, dropping from 17.7% in February 2022 to just 5.3% in March 2023. The latest data release on June 27 showed a y-o-y growth of only 3.1% for the index, clearly highlighting the growing unaffordability of housing in the US.
This trend is inversely correlated with data on the US 30-Year Mortgage Rate. On March 16, 2022, just one day before the first rate hike, the mortgage rate stood at 4.27%. According to the most recent report on July 12, the mortgage rate has jumped to 7.07%, a level unseen since 2002.
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Exercising caution
While recent economic data has indicated a slowdown in inflation and consumer spending, it is sensible to exercise caution and await further validation from job data before considering the possibility of a rate cut in 2023. The latest employment figures suggest that the FOMC may not feel compelled to reduce rates shortly, as the job market has demonstrated resilience.
In March 2022, the unemployment rate stood at 3.8%, and it remained relatively stable, with a marginal decline to 3.6% in July 2023. Additionally, Nonfarm Payrolls increased by 750,000 jobs in March 2022 but only added 209,000 jobs in July 2023. These observations indicate that the job market is saturated, and employment growth is gradually slowing.
The possible rate cuts by the FOMC depend on additional evidence of a weakening job market, declining inflation, and reduced consumer spending. Only then will the case for rate cuts be reinforced. In remarks by Director Lael Brainard of the US National Economic Council in late June this year, it was suggested that inflation could reach approximately 2% by November 2024. This offers a positive outlook for rate cuts in the latter half of 2024.
Aligned with the FOMC’s projections for long-term inflation, it is important to note that in December 2022, FOMC participants generally expressed that adopting a restrictive policy approach until inflation reaches a sustainable path towards the 2% target is warranted.
This stance reflects the FOMC’s uncertainty about the timing of inflation returning to the targeted 2% long-term rate, thus justifying their support for a hawkish rate hike policy.
There has been a shift in perspectives since the June meeting. The minutes from this gathering suggest that the FOMC now perceives the 2% long-term inflation target to be within reach, indicating a potential change in their outlook.
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FOMC’s dot plot forecast
According to the latest dot plot release in June (Table 2), most FOMC members foresee the interest rate in 2023 to be within the range of 5.50% and 5.75%. Looking ahead to 2024, the FOMC expects the interest rate to decline, projected to be 4.25% to 5.25%. The forecast for 2025 appears even more optimistic, with predictions indicating a further decrease to a range of 2.25% to 4.25%. Beyond 2025, the FOMC’s long-term projections suggest that interest rates will converge towards an average of approximately 2.5%.
Based on the June dot plot, the FOMC’s current projections anticipate a gradual decrease in interest rates from 2023 onwards, albeit with varying degrees. Moreover, according to the July FOMC meeting, this may change as Powell leaves the rate hike decision open and intends to evaluate economic data before making his decision.
Investment suggestion
Consequently, based on the forecast above indicating a downward trajectory in the Fed funds rate, the S-REITs sector appears to hold promising prospects, as historical data supports.
The distribution per unit (DPU) of S-REITs is closely related to the Fed fund’s rate. One of the largest holdings in the Lion-Phillip S-Reit ETF — Mapletree Industrial Trust (MIT) — illustrates this.
MIT, a significant holding in the ETF, recently disclosed its 4Q FY2022/2023 results, emphasising its sensitivity to interest rate fluctuations, especially about its floating rate loans.
The report indicated that a 50 bps increase in interest rates would lead to a 0.7% decline in its DPU. This demonstrates the relationship between the FOMC’s interest rate decisions and REITs’ DPU. As the FOMC raises interest rates, borrowing costs increase, forcing REITs to allocate a larger portion of their distributable income to cover expenses, ultimately reducing DPU. While this phenomenon is relevant for all REITs, the specific values are particular to MIT. Each REIT’s impact on DPU can vary, depending on their fixed and floating rate loan mix.
Nevertheless, if signs emerge suggesting the FOMC’s interest rate may lower, a prudent choice would be to explore the potential of a diversified S-REIT ETF, the Lion-Phillip S-Reit ETF includes a diverse array of REITs, with the composition consisting of 46.41% large-cap REITs and 47.85% allocated to smaller-cap REITs. This balance allows investors to offset the lower yields typically associated with larger market cap REITs with the potentially higher yields offered by smaller market cap REITs, which also tend to carry higher risk.
The ETF’s year-to-date capital appreciation of 3.22% this year is also noteworthy. This demonstrates investors aligning their expectations with the FOMC’s projections for a decrease in interest rates in 2024 and 2025. This performance further strengthens the investment case for the ETF, making it an appealing option for those seeking exposure to the potential benefits that could arise from the anticipated decline in interest rates.
Tan Jun Sen is a dealer with Phillip Securities — Holland PIC
