As I said last week in the column "Time to Discuss Mortgage REITs Again," one of the principal reasons for the depressed prices for the real estate investment trusts, and the resulting double-digit dividend percentages, is the fear that interest rates are about to rise in the U.S.
The logic of the argument from which this fear is being generated is that the Federal Reserve is in the process of "normalizing" the fed funds rate. The consensus expectation is that the Fed will complete the tapering process within the next six months, leave the fed funds rate at the current 0-25 basis points for six months after that, then start raising it about mid-2015, getting to 1% by the end of 2015 and 2.25% by the end of 2016.
For the purposes of this column, that's far enough out to look.
If the Fed were to follow this trajectory, conventional neoclassical economic theory posits that economic activity should increase along with inflation and expectations for it and that bond traders will drive long-end Treasury yields up by at least the same amount as the fed funds rate. That implies 10-year Treasury yields of 3.5% by the end of 2015 and 4.75% by the end of 2016. And that implies that 30-year fixed mortgage rates will head higher to the same degree, and that would again cause the value of the existing mortgages held by the REITs to decline and thus drive down the price at which they trade.
The issue for investors to consider is whether this logic is sound. The available economic data do not support it.
In order for such a trajectory and all of the necessary linkages between them to be logical, bank lending must show signs of increasing, along with expectations for it to continue and accelerate.
An increase in bank lending is typically preceded by an increase in consumer spending. This increase sends the signal to corporate borrowers and lenders that an increase in economic activity has begun, and that decreases the risks of both loan-taking and loan-making.
Demand for loans increases commensurate with lenders' guidelines for making them less restrictive. This isn't happening, though. Consumption isn't increasing, and thus neither is anything else that typically follows. The U.S. economy is caught in a rut, as I discussed last month in the column "The Great Stagnation and Stocks."
Without bank lending increasing, the process outlined above can't happen. That doesn't mean the Fed won't remove the current quantitative easing, though. It just means that doing so probably won't cause an increase in economic activity, inflation, long-end Treasury yields or mortgage rates.
I'll discuss the Fed's logical strategy and motivation for attempting to normalize interest rates in more detail tomorrow.
One of the probable reasons for projecting this now and allowing markets to anticipate it is that the Fed is indeed trying to push on a string. What I mean is that the way the Fed has managed its quantitative-easing programs has failed to cause "animal spirits" to increase by way of lowering the cost of capital.
Capital has been cheap for so long that the Fed is probably concerned that it has conditioned borrowers into believing that it will be cheap indefinitely, and therefore potential borrowers feel less urgency to capitalize on it. This is a part of what is known as the "paradox of thrift," which I discussed in October 2012.
Whether or not Fed policy of maintaining low interest rates for so long has unwittingly exacerbated the increase in savings and reduction in consumption cannot be known for certain. What we do know, though, is that low rates haven't worked to cause an increase in economic activity. Maybe the answer, then, is to do the opposite and start increasing the cost of debt capital.
In marketing, this is known as "the takeaway sale," and it is ubiquitous in advertising with catch phrases designed to motivate a consumer into taking an action by providing a time limit on how long a price for a good or service may be available.
We see this evidenced in phrases such as "limited time offer," "offer expires at midnight," "act now and get free shipping," "for the first 100 callers" and so on.
This is a risky strategy, because if it fails to motivate consumers, the Fed loses credibility with everyone. The Fed, however, is signaling that it intends to continue with the tapering process and eventually raise the fed funds rate, even as the economy is not doing well.
If the Fed is to be successful, it will have to result in a marked increase in housing activity caused by home buyers moving to access cheap mortgage capital before it goes away.