The article below is reprinted with permission from The Capital Issue, a quarterly newsletter published by Lancaster Pollard.
In September of 2007, the U.S. Federal Reserve began to lower the federal funds rate in response to a decrease in economic activity. The target federal funds rate, the interest rate the Fed uses to conduct monetary policy, was lowered from 5.25 percent in August 2007 to 0-0.25 percent by December 2008. This 0-0.25 percent level still exists today.
In addition to keeping the fed funds rate near zero, the Fed began purchasing longer term securities in order to decrease long-term interest rates and further stimulate the sputtering economy. This process, known as quantitative easing, began in November 2008 and has continued, in some form or another, to today.
Quantitative easing has been successful in lowering long-term interest rates, as is evident by the decline in the 10-year U.S. Treasury yield. From November 2008 through June 2013, the 10-year UST yield fell from around 4 percent to 2.5 percent, reaching a low of 1.43 percent in July 2012. In addition to lowering long-term rates, quantitative easing has contributed to improving economic conditions, albeit slowly, with declines in the domestic unemployment rate and positive GDP growth signaling a growing economy. Despite the improvements to economic conditions, the Fed has continued to target record low short term rates and open market bond purchases of $85 billion per month.
Fed Chairman Ben Bernanke has stated that the Fed will look to continue with a target fed funds rate of 0-0.25 percent until the unemployment rate reaches 6.5 percent and annual inflation exceeds 2 percent. On June 19, 2013, after a two-day meeting of the Fed, Chairman Bernanke reaffirmed that these targets must be met before an increase in the fed funds rate is considered. However, the chairman also commented that the economic outlook was promising and a reduction of bond purchases could occur before the end of 2013.The announcement of potential tapering led to a sell-off in many asset classes. On the day of the announcement, the Dow Jones Industrial Average declined 1.3 percent and 2.3 percent the following day. The bond market also suffered from the news, with the 10-year UST yield rising from 2.20 percent the day before the announcement to 2.41 percent the day after. Less than two weeks after the comment, 10-year UST yields hit a high of 2.73 percent.
10-Year US Treasury yield
Chairman Bernanke did his best to calm the volatile markets by emphasizing that the target fed funds rate will remain near zero and monetary policy will continue to be accommodative. Bernanke compared the economy to an accelerating automobile; tapering bond purchases was the equivalent of letting off the accelerator, while increasing the target rate would be applying the brakes. He stressed that although economic conditions were improving, the country is still far from reaching the desired unemployment and inflation targets of 6.5% and 2%, respectively.
International troubles
The United States is not the only country taking action to ensure a healthy economic recovery. The Great Recession spread far across the globe and some countries and regions are struggling to resume economic growth, including:
Europe – Despite a promising economic recovery in countries, such as Germany, Europe remains stuck in a recession. High levels of debt in countries, such as Portugal, Spain and Greece, have increased the possibilities of default, and potentially severe consequences for the Euro currency. In response to a troubling economic environment, European Central Bank President Mario Draghi committed to keep crucial interest rates at low levels in an early July press conference. On the same day, Bank of England Governor Mark Carney pledged to continue low interest rates and bond purchases to stimulate the economy. The continued stimulus of European economies is in contrast to plans to taper stimulus in the United States and reflects the strength of the U.S. recovery relative to peers.
Japan – The nation has been stuck in a period of stagnant economic growth and deflation for 15 years. Earlier this year, under pressure from newly elected Prime Minister Shinzo Abe, its central bank began a strategy of economic stimulus aimed at improving economic conditions. The Bank of Japan began purchasing bonds in an effort to provide stimulus and hopes to reach a 2 percent inflation target in the medium term.
China – One of the world’s fastest growing economies has not been immune to interest rate troubles in 2013. In mid-June, the Shanghai interbank offered rate, the interest rate on overnight loans made from one bank to another, briefly rose to 30 percent from 2.5 percent earlier in the year. This rate shock (dubbed the SHIBOR Shock in the media) raised fears of possible bank defaults, caused panic within financial institutions, and led to a sharp sell-off in the stock market. The primary reason behind this sharp rise in the SHIBOR rate lies in the central bank’s (People's Bank of China) immediate unwillingness to lend cash to the country’s banks. There is significant uncertainty regarding why the central bank refused to come to the rescue, but it can likely be tied to the government’s fears that access to credit is growing too rapidly and the lending is having little impact on growth. There are fears that the government’s efforts to decrease credit access could have negative implications for growth going forward.
Where Are domestic rates headed?
The Fed has pledged to keep rates low in the near-term and there is not much evidence that would lead one to believe they will not be true to their word. Given the Fed’s commitment and the current economic situation, it seems most likely that interest rates will remain around current levels through the end of the year.
Unemployment and inflation rate
Although economic conditions are improving, both unemployment and inflation are still off their target rates and are likely to remain off target in the near-term. A Bloomberg survey of 68 economists found that most firms are not forecasting unemployment to fall below 6.5 percent until 2015, at the earliest.1 A similar survey of 69 economists found that most do not anticipate inflation exceeding 2 percent until 2015. 2 The Fed has released a similar forecast and does not anticipate raising the fed funds rate until 2015. Given this information, it is likely that interest rates will remain relatively unchanged throughout the rest of this year.
Tapering is expected to have some impact on long-term interest rates, although this effect is probably already factored into current yields. For example, yields spiked at the initial announcement of potential tapering, but have since decreased. Tapering will likely begin by the end of the year. A survey of 67 economists showed that the average expected rate for the 10-year UST at the end of 2013 is 2.62 percent, only slightly higher than the closing rate on July 25, 2013 of 2.57 percent.3 A greater than anticipated tapering of bond purchases or a sudden spike in inflation could cause yields to be substantially higher by the end of the year, but these events seem unlikely and we anticipate both long-term and short-term rates will close out the year close to current levels.
In addition to unemployment and inflation, market participants should pay close attention to the pending retirement of Fed Chairman Bernanke. The chairman's policies have been quite radical in a historical context and how his successor chooses to continue these policies will have a definite impact on interest rates.
One front runner for the position appears to be Janet Yellen, the current vice chair of the Fed. She shares the Chairman's dovish view of monetary policy and has experience within the Fed. (Dovish refers to a preference for accommodative monetary policy, while hawkish implies an inclination toward a restrictive monetary policy.) If Yellen were to take over the position, one could expect interest rates to remain relatively unchanged as she is likely to continue current policy. However, if a more hawkish member of the Fed were to become chairman, we would expect policy to tighten and interest rates to subsequently rise.
Finding the silver lining
For providers, the recent increase in interest rates has certainly cut into savings associated with refinancings. Nevertheless, the government agency programs continue to offer opportunities for 35-year, fixed interest rates below 5 percent. Should interest rates continue to rise into 2014, it is likely variable-interest-rate structures, which have been stuck at floors between 3 percent and 4 percent, will become more popular in comparison to the fixed-interest-rate vehicles.
Although the upward pressure on interest rates presents challenges, there are a number of benefits associated with a strengthening U.S. economy. Foremost for health care providers heavily dependent on Medicaid revenue, is improving state budgets. The Wall Street Journal reported on July 5 that states have experienced a 17 percent increase in tax collections. Looking to 2014, a survey by the National Governors Association reported that only 13 states are expected to face budget deficits instead of a previously predicted 31. The improving state revenues should allow providers to protect Medicaid funding and, ideally, make-up some of the cuts enacted over the last five years.
Similarly, a strengthening economy should continue to make it easier for seniors to sell their homes and move into retirement communities. Since bottoming out in the first quarter of 2012, the S&P/Case-Shiller median home price has increased approximately 10 percent to $176,000. Although not directly linked, over the same time period the National Investment Center for Seniors Housing & Care Industry reported a steady increase in average senior housing occupancy to 89 percent. Of note, both indexes remain well below their pre-2008 highs, offering an additional upside.
For hospitals a benefit of the strengthening economy has been a reduction in bad debt expense as more individuals are able to pay their medical bills. S&P, which publishes annual medians for its rated hospitals and health systems, has reported the bad debt expense percentage trending back down after increasing to 5.9 percent of net patient revenue in 2008. Based on a medium annual revenue base of $436 million, returning to prerecession bad debt levels represents nearly $2 million of additional annual cash flow.
Finally, a strengthening economy also is pulling commercial banks back into lending. The Federal Reserve’s commercial and industrial loan data demonstrate a 25 percent drop in lending during the recession. Over the past two years commercial banks have steadily increased the pipeline of loans and overall levels have nearly reached pre-recession levels. If agency financing becomes less attractive due to rising interest rates, the increase in the availability of commercial bank loans will provide a viable capital funding alternative.
Commercial and industrial loans at commercial banks
While the last several years may have been a fun ride for borrowers, as rates hit all-time lows, the next 18 months are expected to present many new challenges. The good news for all types of providers is that rising interest rates will hopefully be tied to an expanding U.S. economy. The challenges may be changing, but forward-looking organizations will also find many new opportunities. The key, as always, is to be strategic in planning your capital projects.
William M. CoursonWilliam M. Courson is the president of Lancaster Pollard Investment Advisory Group in Columbus. He may be reached at wcourson@lancasterpollard.com.
Bill WilsonBill Wilson is a senior vice president at Lancaster Pollard. He manages the Central States region and is based out of the firm’s office in Lawrence, Kan. He may be reached at bwilson@lancasterpollard.com.
1 “July 2013 Unemployment Forecasts Survey.” Bloomberg L.P.
2 “July 2013 Consumer Price Index Forecasts Survey.” Bloomberg L.P.
3 “July 2013 10-Year Note Forecasts Survey.” Bloomberg L.P.