Spiking 10-Year Treasury Rate Signals Caution for Commercial Real Estate

CBRE’s view is that after the current round of monetary tightening is over and inflation returns to the Fed’s 2% target, the 10-year Treasury rate will fall to an average of about 3.5% over the next five years and settle at 3.25% by 2027. This suggests that average cap rates will be 75 basis points (bps) higher than in the past 10 years, equivalent to a 12.5% reduction in asset values.

Economists who forecast a 4.75% Treasury rate base it on the combination of a projected 2.5% inflation rate, a 1.5% real (after inflation) interest rate and a 0.75% term premium. This expectation is not supported by the experience over the past 10 years when average term premium was negative 0.1% and the average long-term interest rate was 0.58%. Furthermore, the Fed has indicated that it will not allow inflation to trend above 2%.

CBRE’s view is that long-term interest rates are only partly determined by the performance of the U.S. economy. Global factors are also at play. As the world population has aged over the past 30 years, the amount of pension-related savings has grown, with a sizeable amount of it invested in government bonds. This has caused a long-term decline in real interest rates.

In our analysis, we assume that after a period of weak economic growth or recession, the Fed will succeed in reducing inflation to 2% and that GDP growth will average just under 2% for the five years ending in 2027. In addition, global savings levels will stay elevated due to the aging of the population. As a result, we believe that the average 10-year Treasury rate over the five years ending in mid-2028 will be only 3.5%, not the more than 4% that some economists envision.

Certain scenarios that could cause the 10-year Treasury rate to exceed our expected 3.5% average include GDP growth above 2% due to a surge in productivity, an inflation rate of more than 2% and more aggressive quantitative tightening, in which the Fed reduces its balance sheet by holding less bonds for investment. For example, 2.5% GDP growth and 2.5% inflation at current Fed quantitative tightening levels would result in a 4.1% 10-year rate by the end of 2027. Conversely, the average 1.5% GDP growth and 1.8% inflation rates over the past 10 years would lower the projected 10-year rate to 2.8% by year-end 2027.

Figure 1: Historical & Projected 10-Year Treasury Rates

Source: U.S. Treasury Department, CBRE Research.

Factors currently roiling the market will likely dissipate

Four short-term, largely sentiment-driven factors recently pushed the 10-year Treasury rate above the 4% peak predicted by our model:

1. Concerns that the economy may be reaccelerating as reflected in recent upside surprises in housing, retail and industrial production data. We believe the Fed’s monetary tightening will eventually have the desired effect of materially slowing the economy. However, if growth proves more resilient than expected, the Fed could raise rates as high as 6% to ease pressure on the labor market.
2. A near-term bulge in government borrowing. The U.S. Treasury Department plans to borrow $1 trillion in net marketable debt in Q3, $274 billion more than estimated in May. We believe government borrowing will be more orderly after Q3.
3. Ongoing reduction of the Federal Reserve's balance sheet. Our analysis suggests that this process—known as quantitative tightening—does not have a large impact on long-term bond rates. However, it is not uncommon for the market to react negatively in the short term and we may be amid a minor “taper tantrum” as has previously occurred when the Fed curtailed its bond-buying program (Figure 3).
4. Concern that there may be a U.S. government shutdown later this year. While such a risk cannot be ruled out, we think it is unlikely.

As concerns about these factors ease, we believe the 10-year Treasury rate will slowly decline, consistent with the trajectory we outline above.

Figure 2: U.S. Public Debt, Maturity Distribution

Source: U.S. Treasury Department.

Figure 3: Federal Reserve Balance Sheet

Source: U.S. Federal Reserve.

Methodology

CBRE’s econometric model of changes in the 10-year Treasury rate captures the various effects that can be used to forecast the future path of long-term interest rates as detailed in the following table.

The CBRE model makes the real yield on 10-year Treasurys a function of nominal GDP growth, the change in the Federal Reserve’s balance sheet as a percentage of nominal GDP and the share of the world’s population aged 40 to 54. The real yield is defined as the nominal yield less expectations of CPI inflation over the coming 10 years. We also consider the abnormally low yields during the pandemic in Q3 2021. The model uses data beginning in 1982 and reflects the lagged effect of some variables.

A key variable in this analysis is the level of “excess" savings available for investment. This is driven by the variable labeled “share of world population aged 40 to 55,” who are the prime savers in the global economy. The size of this cohort is the most important reason why real interest rates have fallen around the world, particularly in the United States, and why we think that interest rates will not reach 4.75% and stay there. There is simply too much capital in the global economy due to demographic change.

Figure 4: Methodology Table

Note: Dependent Variable = change in real 10-year Treasury rate
Source: CBRE Research.