The Increase in Interest Rates

Two recent developments have brought about a rather significant change in the underlying financial background for the U.S. and global economies. The first of these was the statement by Ben Bernanke, Chairman of the Federal Reserve Board, that the Fed expected the growth of the U.S. economy to re-accelerate in the second half of 2007 and that the Fed was still concerned about an increase in the inflation rate. At the same time, the European Central Bank increased its base lending rate by ½ point, indicating that it too was concerned about inflation.

The immediate result of these developments was a fairly significant rise in medium and long-term interest rates. The bond market had clearly been proceeding on the assumption that the U.S. and global economies would be slowing, that inflation was not much of a problem and that interest rates would be steady to declining over the next six months. But both the U.S. and European central banks have made it clear that they are concerned about the rates of economic growth and the prospects for rising inflationary pressures.
The adjustment that has occurred in the bond market in recent weeks has eliminated the inverted yield curve and, in our view, has put the bond market into a much more rational position. We believe that there are three reasons why this adjustment has taken place. First, there is the growing belief that U.S. economic growth will re-accelerate and the demand for credit will strengthen, a view that was greatly enhanced by the statement of the Fed Chairman. Second, investors seem to agree with the Fed and the European Central Bank that inflation might again become a more serious problem. And finally, the bond market has come to understand that some major investors, such as the Government of China, are taking action to diversify their enormous dollar holdings, by at least moving a portion of their new investments away from U.S. Government bonds.

None of the reasons for the increase in interest rates can be considered to be negatives for the U.S. real estate market. Real estate always does well when underlying economic growth is strong, and real estate, as a hard asset, has to be considered a long-term hedge against inflation. Therefore, while higher interest rates might have an effect on the current yield from leveraged investments, we continue to believe that the real estate market will remain strong, reflecting underlying economic and inflationary trends. And we would continue to urge major institutional investors to diversify their investments away from more traditional investments, particularly fixed income, and to consider a non-correlated investment such as real estate.

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