Interest rates affect every aspect of public and private markets; in particular, risk-free rates affect the valuation of bonds, equities and REITs. Where are rates heading and what should investors do?
The outlook for interest rates has divided the investment community, which is reflected in a recent poll of our readers. Out of about 1,000 readers who responded, 41% forecast rates to fall this year, 33% reckon they will remain at current rates, 19% expect interest rates to rise and 7% said they do not know.
On the other hand, almost all REIT managers — except for a couple — have opted to remain conservative, keeping a high portion of their debt on fixed rates.
On Feb 11, Jerome Powell, chair of the US Federal Reserve, told a Senate committee that with a strong job market and inflation still elevated, he and his colleagues “do not need to be in a hurry” to cut interest rates. In his semi-annual report to Congress, Powell noted that the central bank had lowered its benchmark interest rate by a full percentage point in 2024. Further cuts will likely have to wait until inflation cools further or until there is a notable softening of the job market, Powell had guided. The Fed kept the Federal Funds Rate (FFR) steady at the 4.25%–4.5% range during its January meeting, pausing its rate-cutting cycle after three consecutive reductions last year.
In the US, January’s overall annual inflation rate rose to 3% compared to 2.9% in December 2024 and well above the post-pandemic low of 2.4% in September 2024. In 2022, the overall annual inflation rate rose to more than 9%, albeit briefly.
Gary Dugan, CEO of the Global CIO Office, points out that the jump in core inflation to 3.3% in January, compared to expectations of 3.1%, and marking a 0.4% monthly increase that was the highest since March 2024, raised concerns. “The data also revealed signs of ingrained inflation, with companies implementing annual price increases at the start of the year. With inflation persisting, the conversation around the Fed’s next move has shifted. Markets are now pricing in just one rate cut this year, possibly in late 2025, with a non-negligible risk that the US central bank may even hike rates,” he says.
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The Fed’s actions and announcements are closely watched in Singapore because we do not have an independent monetary policy, unlike Australia, China and Europe.
Singapore has adopted an exchange rate mechanism rather than interest rates as its monetary policy instrument. The Monetary Authority Singapore (MAS) does not attempt to control the level of domestic interest rates, limiting itself to dampening excessive interest rate volatility. Singapore dollar interest rates, as represented by the three-month Singapore Overnight Rate Average (Sora), are largely determined by foreign interest rates and investor expectations of the future movement of the Singapore dollar.
As a result, movements in local Sora and risk-free rates directly correlate with the direction of US FFR and 10-year US treasury yields, respectively. Their trends are the same, but their absolute values are different (see Charts 1 and 2). The main difference is that our Sora benchmarks fluctuate much more than the FFR, which only changes when the Fed raises or lowers the rate.
See also: Elite UK REIT divests vacant Wales property at 18% above valuation
Peppered with uncertainties
During EdgeProp Singapore’s 2025: outlook for the property market forum on Feb 16, questions swirled around some topics, including interest rates and the discount to book value of developers’ trading prices.
Song Seng Wun, economic advisor to CGS International, says a new variable has been introduced to the inflation-interest rate outlook since November: US President Donald Trump’s economic policies are an upside risk to inflation.
Song says: “Inflation is rising at a much slower pace, but importantly, we are still seeing economic growth, not just around the region and around the world, but also in Singapore. Therefore, theoretically, we should see interest rates coming off, tracking lower inflation.” However, because of impending tariffs by the Trump administration on friend and foe alike, “there is upside risk to inflation, and upside risk to interest rates”, adds Song.
Alan Cheong, executive director of research and consultancy at Savills, who was also at the EdgeProp forum, says interest rates are now expected to hold up for longer. “There are also mitigating points. One of the reasons for inflation was a transition from fossil fuels to clean energy, but Trump has exited from the Paris Accord, which could mitigate some of the upside pressures,” adds Cheong.
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The outlook for interest rates is likely to be peppered with uncertainties. As a case in point, when asked, Serena Teo, CEO of CapitaLand Ascott Trust ’s manager, said during a results briefing in January: “I’m not sure that the answer I give today will continue to be the same tomorrow. But I can give you my view as of today. I think the market expects some lowering of interest rates this year. The biggest question that everybody has on their minds is really by how much?”
Eugene Leow, senior rates strategist at DBS Group Research, says Treasury Secretary Scott Bessent has shifted the market’s attention towards containing 10-year US Treasury yields, given that Trump has been unable to pressure the Fed to cut its FFR.
Given that US funding costs are more closely tied to longer-term yields, Leow argues this makes sense. However, the US budget deficit (7.2% on a rolling 12-month basis) and robust growth momentum are putting significant upward pressure on US treasury yields. In addition, the Fed is running a quantitative tightening (QT) programme of US$60 billion ($80.5 billion) a month to alleviate its somewhat bloated balance sheet.
The Fed used quantitative easing and Operation Twist (when it sold shorter-term treasuries to buy longer-term treasuries) over the past 20 years to combat various crises, including the Global Financial Crisis and the Covid-19 pandemic. However, these measures are unlikely to be implemented when the economy is growing and inflation is prevalent.
Reuters has reported that one way to lower treasury yields is the deregulation of the US banking system. The report says some traders believe US regulators may review the supplementary leverage ratio (SLR). US banks are required to maintain an SLR of 5% more of Common Equity Tier 1 capital relative to their total leverage ratio. In 2020, the Fed temporarily excluded treasuries and reserve deposits from the 5% minimum SLR and reimposed the conditions in 2021. Economists and analysts suggest that US Treasuries could be permanently exempt from the SLR.
“From a regulatory standpoint, an exemption of US treasuries from the SLR rule looks very likely after Fed Chair Powell noted that the Fed will take another look. Banks will be inclined to extend duration out to the intermediate tenors. The bond swap spread for those tenors would also similarly benefit. We gauge this to have a moderate impact on Treasuries with a high likelihood of going through,” Leow says.
The best way to lower Treasury yields is to reduce the deficit, which is unlikely in Trump 2.0. Scrapping the SLR rule and stopping QT could also lower yields. Instead, Leow is expecting upward pressure on 10-year and 30-year treasury yields, causing the 5Y/30Y curve to steepen (see Chart 3).
Why interest rates are important
Interest rates affect every aspect of the public and private markets, property valuations, demand and supply, REITs, banks, businesses and the general public in different ways. In particular, risk-free rates affect bonds, equity and REIT valuations.
REITs and bonds are directly and indirectly affected by interest rates, especially risk-free rates (10-year bond yields). For one thing, both REITs and bonds take their prices from the level of risk-free rates and their trends. REITs usually reference their market prices based on the spread between their distributions per unit (DPU) yields and risk-free rates (also known as the yield spread).
Secondly, interest rates affect borrowers’ cost of debt. Rising interest rates make it more expensive for REITs to borrow, and hence, their DPUs are negatively impacted unless rents and net property income can outpace the rise in their average cost of debt.
Their approach to capital management reflects REIT managers’ outlook on interest rates. Our Big REIT table shows four S-REITs with fixed rate debt levels of below 70% as at Dec 31, 2024 for REITs with December year-ends. Of these Keppel REIT is at 69%, Keppel Pacific Oak US REIT is at 66%, and First REIT is at 57.9%. CDL Hospitality Trusts fixed rate debt is the lowest at 32.1%.
As an example, Digital Core REIT’s (DC REIT) fixed debt comprises 86% of the REIT’s total debt. Dave Craft, CEO of Digital Core REIT’s manager, says: “Those fixes are long enough to give us a lot of comfort and protection against unfavourable movements of interest rates. The fixed portion is durable through 2025. The floating portion is only 14% of our debt.” Craft believes a higher fixed rate is safer despite some economists expecting two rate cuts by the Fed this year.
Interest rates indirectly affect the capital values of investment properties as discount rates used in discounted cash flow computations take their levels from prevailing interest rates.
Companies borrow at interest rates influenced by the FFR. A rising FFR causes borrowing costs to rise. Additionally, the required rate of return on equity (the cost of equity) could also increase as investors seek higher returns. The discount rate reflects the company’s or the asset’s cost of debt and cost of equity (which together make up the weighted average cost of capital or WACC).
For an investment property, the input, in addition to the discount rate, is cash flow, which is dependent on rents. DC REIT’s asset valuations rose because the outlook for rents and cash flow compensated for the expansion of discount rates and capitalisation rates in the US. While its full-year DPU fell 2.7% in FY2024 to 3.6 US cents, net asset value rose by 14.9% y-o-y to 77 US cents (excluding DPU) as at Dec 31, 2024.
The valuations of the Australian portfolios of Keppel REIT and CapitaLand Integrated Commercial Trust (CICT) declined because capitalisation rates and discount rates rose. Still, the outlook for rents and cash flows did not expand sufficiently to offset the discount and capitalisation rate gains.
The valuations of equities also depend on interest rates. One of the valuation methods for equities is the capital asset pricing model (CAPM), which uses risk-free rates, market risk premium and the volatility of the stock against the market (known as beta). The CAPM shows that the expected return on a security is equal to the risk-free return plus a risk premium based on the beta of the stock.
China’s risk-free rates have been falling since the 4Q2020 (see Chart 4). The decline accelerated from 4Q2023 onwards as investors became increasingly nervous about deflation in China. Despite these concerns, Chinese equity markets, particularly Chinese tech stocks, have rallied strongly. This is evidenced by the Hang Seng Tech Index’s price gain of 23%, outpacing the S&P500’s 3.9% gain and the Nasdaq Composite Index’s 3.7% rise since the start of the year to Feb 17.
Perversely, just as the US economy is a bit too hot and likely to get hotter with Trump’s expansionary fiscal policies, the Chinese economy has slowed and continues to cool. At the start of the year, the People’s Bank of China (PBOC) said it would maintain a “moderately loose monetary policy in 2025” with sufficient liquidity and increased social financing. The PBOC also indicated that it will use a mix of monetary policy tools to reduce the reserve requirement ratio (for banks). Since the start of the year, China’s risk-free rates have fallen to a low of 1.63% before rebounding. The PBOC left its one-year loan prime rate unchanged at 3.1% in January.
Lower rates in Europe and Australia
Although China’s easier all-round monetary policy helped to raise the interest coverage ratio of CapitaLand China Trust , its average cost of debt in 4QFY2024 was a tad higher than in 3QFY2024. The REIT’s manager has stated that it plans to increase its RMB debt to 35% of total debt, up from around 20% as at Dec 31, 2024, to take advantage of cheaper funding.
The REITs most impacted by the Fed’s relatively hawkish outlook are likely to be those with a majority of properties in the US, such as Manulife US REIT, Prime US REIT and Keppel Pacific Oak US REIT. These REITs have either greatly reduced their DPUs or stopped distributions altogether.
On Feb 18, the Reserve Bank of Australia (RBA) announced it had lowered its cash rate target to 4.10% and the interest rate paid on Exchange Settlement balances to 4%. On Feb 7, the Bank of England cut its interest rates by 25 basis points (bps) to 4.5%, the lowest level in 18 months. In January, the European Central Bank (ECB) lowered its key deposit facility rate by 25 bps to 2.75%. Elite REIT owns a UK-based portfolio; IREIT Global and Stoneweg European REIT own European-based portfolios.
The RBA lowered its rates because Australia is winning the fight against inflation. The BoE and ECB lowered their rates because of slow growth. US real GDP rose by 2.8% in 2024. Trumpian policies are designed to increase US GDP further this year.
Operationally, the Fed should be acting countercyclically to smooth out economic cycles. Rates should, therefore, be high, DBS’s Leow argues. If fiscal dominance becomes a theme, the Fed may lose independence and act in coordination with the Treasury to manage financing costs, he adds. Such a move would be just short of disastrous, and Leow sees it as a “tail risk for now”.
“With inflation proving resilient and tariff battles looming, the risks are skewed toward higher prices. While the most likely outcome is rates holding steady, investors must prepare for all possibilities — including a rate hike,” Dugan says.
What should investors do? Investors expecting rates to fall should opt for growth stocks and REITs; for those expecting rates to stay the same, hold the banks; and for those expecting rates to rise, look at Chinese stocks where risk-free rates are at a five-year low.
Click here to view the REIT table
