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This time could be different

​Don't look now, but inflation and yields start to rise

Historically, when risk-free interest rates rise, they tend to do so abruptly. Even during the last five years, when rates have seemingly been stuck at low levels, the benchmark 10-year Treasury rate jumped quickly when it began to rise. In 2013 the 10-year Treasury yield increased roughly 138 basis points in seven months; in 2015 it increased roughly 82 basis points in four months; in 2016 it increased 125 basis points in eight months. But in each instance that momentum was not sustained. Once again, that 10-year Treasury yield has started to rise. From a low in September it has increased roughly 50 basis points to its highest level since last March. With each previous increase sustained inflationary pressure was missing. Could that be changing? The bond market seems to think so and recent data supports this view. The headline consumer price index (CPI) increased only slightly and actually declined on a year-over-year basis due to softening gasoline prices. But the core CPI, which excludes volatile food and energy, increased sharply last month driven by a wide variety of categories. Quietly, core inflationary pressures gained momentum in 2017, indicating that December's result was not completely idiosyncratic. In the first half of 2017 core inflation increased at an annual rate of 1.3 percent. That rate jumped to 2.2 percent in the second half of 2017 and 2.5 percent during the fourth quarter. ​

False dawns have previously broken, with core inflation running up only to fall back. This should happen again in January and February thanks to unfavorable base effects (prices were relatively high in January and February last year when core inflation was rising). But as we mentioned last week, the game is changing. 

The labor market continues to tighten, putting upward pressure on wages, and the impending tax cuts, which have yet to take effect, appear to already be fueling wage increases at a number of companies.

Consumer behavior reflects this environment: retail sales for December rose strongly and holiday sales grew at the fastest rate since 2015, when the economy was growing at its fastest rate since the recession. If tax cuts and wage increases continue to hold buoyant consumer spirits aloft, core inflation pressures could be maintained.

This surge in core inflation should provide the Fed with enough fodder to raise rates when it meets in March. The futures market is already assigning a roughly 73 percent probability that the Fed will raise rates 25 basis points at that meeting, in line with our expectations. That would mark the sixth increase since the Fed began tightening in December 2015. During the two previous expansions when the Fed was raising rates faster than the current cycle, core inflation peaked at around 2.8 percent to 2.9 percent on a year-over-year basis. At 1.8 percent we remain roughly 100 basis points from that threshold. But in both of those previous cycles, inflation jumped a similar 100 basis points in roughly 12 months to reach those cyclical peaks. The Fed will be paying close attention to inflationary pressures over the next quarter or two as the impact of tax cuts begins.

What it means for CRE: The tendency for rates to rise quickly and the potential for tax legislation to rapidly change the inflation dynamic means that CRE investors should not be complacent. While we cannot guarantee that this is the inflection point markets have been waiting for, at a minimum, the changes in the labor market and tax legislation provide the most conducive economic environment for a breakout since before the recession. If things change quickly, investors will not want to get caught flat-footed. We currently forecast three rate hikes of 25 basis points each for 2018. But if things break correctly, that could easily turn into four rate hikes. We have not yet reached the point where interest rate increases have a serious impact on the CRE markets. But add another 75 to 100 basis points to the market and we get ever closer to that point. 

What else happened last week

Another inflation gauge, the producer price index (PPI), fell slightly during December, but the year-over-year growth rate for both the headline and core PPI increased slightly to their highest levels since 2012. Retail sales also grew strongly in November as well as December, particularly core retail sales which grew a significant 1.4 percent in November.

What we are watching this week

Housing starts for December should show a slight decline after a relatively strong showing in November due to hurricane impact. Meanwhile, building permits for December should remain little changed from November's level. Overall, both series are trending slowly upward though both starts and permits remain far below levels seen during previous economic expansions. 

More robust residential housing construction remains a key missing ingredient from stronger economic growth and the exact impact on residential construction from the tax code changes remains highly uncertain. 

Thought of the week

The 2-year Treasury yield crossed the 2-percent threshold for the first time since 2008 last week.

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