Interest Rates to Face Pressure of Fed Balance Sheet Tightening

Federal Reserve Likely to Begin Balance Sheet Reductions;
Investors Anticipate Rising Interest Rate Climate

Steady economic performance and the tightened labor market have encouraged the Fed to begin normalizing its balance sheet. Since starting quantitative easing in 2008, the Fed has amassed $4.5 trillion in mortgages, bonds and other assets. In a move likely to put upward pressure on long-term interest rates, the Fed will begin winding down its portfolio. The Fed will engage this process cautiously over a prolonged period.

Key Findings:

The Fed balance sheet reduction will place upward pressure on long-term interest rates, which have been range-bound in recent months. Foreign investment in U.S. Treasurys could partially offset this movement.
The Fed will closely monitor the yield spread between long- and short-term rates, a key indicator of an impending recession.
Commercial real estate yields still offer a premium over the Treasury rates, but the spread could tighten as interest rates rise. Investor caution remains elevated, moderating transaction activity, but the flow of capital to the sector is still elevated by historical standards.

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