Markets Scale Back Rate Cut Expectations
What You Missed
The Fed is doing its best to instill fear of more rate hikes in the minds of financial markets, but no one is buying it. Despite Fed Chair Powell’s best efforts during his scheduled testimony to Congress last week, market expectations of the fed funds rate barely budged, and are still pricing in a peak of 5.50%, implying just one more hike – in July – and rate cuts by year-end.
Running the Numbers: Diminished Odds of Recession
Interest rates across the maturity spectrum were mixed, with all reaching fresh mid-week highs, only to fall back to earth to finish the week about where they started. The crosscurrents of a persistently robust jobs market, stubbornly high inflation, a Fed that seems to be near the end of its tightening cycle, and new geopolitical tensions (Russia) dominating moves. For the week, the 2, 5, 10 and 30-year Treasury yields rose a modest 5, 2, 1 and 1 basis points respectively, to 4.74%, 3.98%, 3.72% and 3.81%. Pressure persisted in the 2s-10s Treasury yield spread, a widely watched barometer of recession potential, to trade at -101 basis points, at the higher end of the recent range of -108 from a couple of months ago.
With the yield curve implying that a major recession is around the corner, coupled with diminished market expectations of a recession, one must wonder: Is the yield curve signaling mechanism broken? That’s a topic of intense debate. It is certainly true that in the new world of over the top forward guidance from the Fed, one can assume that the curve’s signaling mechanism is more watered down that it has ever been. Should it be discarded? No, but the curve signaling is seemingly less reliable than in the past. Time will tell.
3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, rose a modest 1 basis point to 5.23%. The implied yield on the 3-month SOFR futures contract 1-year forward (June ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, rose one basis point week over week, to 4.49%, reflecting the ongoing uncertainty surrounding the probability of more Fed rate hikes through the summer and fall.
The SOFR futures market, and the forward curve it projects to the world, implies that 3-month SOFR is already near its peak, and expects it to peak in the fall, at 5.31%, then decline consistently over the next year as the Fed eventually eases. Swap markets still predict a rate cut by the end of this year, reflecting the seeming resilience of the US economy, but one that falls into a mild recession in Q4 2023. It’s all part of an emerging theme of deeply diminished expectations that the Fed’s 500 basis points of cumulative rate hikes are poised to set off a sharp recession.
Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, fell throughout the week. Elsewhere, equities were lower on the week amid continued positioning from the Fed that rates are going even higher. The price of a barrel of West Texas Intermediate crude oil slipped $3 to $69.30, while the US Dollar strengthened, and gold weakened.
Borrowers Beware: The LIBOR to SOFR Transition Is Not Your Friend
We’re being flooded with calls and emails from borrowers who were recently informed by their lender that their LIBOR-based, floating rate loan would be converting to a new floating rate index, SOFR. Don’t be fooled, there is nothing standard or routine about transitioning the index in your loan or transitioning the index in your rate cap or interest rate swap.
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Powell’s Higher-for-Longer Signal Ignored by the Markets
In his Congressional testimony last week, Fed Chair Powell made the most of the limited moments he found to emphasize that the Fed may continue hiking rates, much like he did after the FOMC’s decision to pause hikes on June 14th. However, markets scarcely changed as he spoke and did not price in any additional rate hikes, demonstrating once more that Powell’s message was ineffective on its intended audience.
Recent studies have questioned the job market’s function and the need for wage growth to slow to reduce inflation pressures. Powell made it clear that the demand for labor is what is ultimately driving inflation – a tight jobs market pushes wages higher, thus giving consumers more money to spend, keeping inflation pressures uncomfortably high – and that easing the tight job-market is a necessary condition to smother inflation, appearing to separate himself from those viewpoints.
Our take: It seems that the Fed Chair believes that squelching inflation once and for all is dependent on the health of the jobs market. However, if the jobs market begins to suffer significantly due to an economic recession, the Fed will seemingly come to the rescue with rate cuts, even if inflation pressures remain above the Fed’s 2% target. With the jobs market starting to show signs of weakness, and with inflation pressures seeming to moderate, that viewpoint makes financial markets skeptical that the Fed is willing to hike rates much further.
Jobs Market Will Soon Show Damage from Fed Rate Hikes
Jobless claims, a weekly gauge of individuals applying for unemployment benefits, have held above their pre-pandemic average of 218k from 2019 and May’s average of 230k. However, the run-up in claims is concentrated in a small number of states. When looking through a broader, national lens, jobless claims in most states continue to be below the 2019 average.
Our take: With little to no increase in the unemployment rate over the past year, the drop in job openings has been the primary factor in the job market’s gradual but steady cooling. We suspect that the situation will worsen through the remainder of 2023 as the effects of the Fed’s 500 basis points in cumulative rate hikes take their toll on the economy, eventually pushing the unemployment rate higher, to 4.3% by mid-2024, from the current 3.7%. The core consumer price index (CPI) and core personal consumption expenditures index (PCE) – both key gauges of inflation – are expected to reach 4.3% and 4.0%, respectively, in the Q4 of this year, which is almost double the Fed’s 2% target.
The billion-dollar question: How will the worsening jobs picture affect the Fed’s appetite for additional rate hikes? If the weakening jobs scenario comes to fruition, the Fed would likely be scared off from hiking further but would also avoid rate cuts if inflation remains uncomfortably high. Said another way, rates will stay higher for longer than markets expect, and we likely won’t see rate cuts until Q1 or Q2 next year.
What about the recession we’ve all been waiting for?
The US economy has held up well through a series of negative shocks this year: The banking sector instability following Silicon Valley Bank’s (SVB) failure in March didn’t tighten credit as much as anticipated, and the debt-ceiling stalemate was settled without having any real impact on the financial markets.
The biggest obstacle that’s still out there is the lingering effects from the 500 basis points Fed rate hikes. But even still, most have now scrapped their belief that the Fed’s rate hiking campaign will soon wreck the economy and have pushed any real slowdown to late in 2023 at soonest, implying that the need for rate cuts is much further down the road. That being said, the worst is probably yet to come for credit, despite the stock market’s rise this year and the housing market appearing to have stabilized. We’d guess that increased consumer and corporate defaults brought on by a slowing economy will eventually limit the availability of credit for everyone else.
According to the most recent survey of economists, the US economy is now predicted to barely avoid a recession this year, and that inflation pressures will persist longer than anticipated. Gross domestic product, aka economic growth, is now expected to fall only in Q4, but show no signs of weakness before then.
With the outlook growing less uncertain, the swings in interest rates have been less severe. Since March, when it hit its highest level since 2008, the ICE BofA MOVE Index, a frequently watched proxy for interest rate volatility, and by extension rate cap costs, has fallen by almost half.
All told, it’s a dynamic that allows the Fed to keep threatening a limited number of additional rate hikes in the near-term.
What to Watch: Inflation Signals to Further Challenge the Fed
Despite the Fed Chair’s best efforts, financial markets are pricing in just one more 25-basis-point rate hike, in July, and the expectation that the Fed’s next move after July will be to cut interest rates, but not until the end of the year, at soonest. That’s counter to what the Fed’s June dot plot suggests: two more rate hikes this year, followed by a long spate of time before the Fed finally cuts rates in 2024.
The age-old question is now front and center once again: which view will prevail? While we’re siding with the market view, data from the upcoming week will help support it. Fed Chair Powell’s favorite inflation gauge, the “supercore” inflation rate (aka core services excluding housing, contained in Friday’s PCE report), is expected to have dropped to a more subdued pace in May.
Elsewhere, gauges of consumer demand (consumer spending, Friday, consumer sentiment and durable goods orders, both Tuesday) should show more signs of cooling. Initial unemployment claims (Thurs.) should also show that the jobs picture is worsening. Finally, housing (via pending home sales, Thurs.) will eventually cool off again as the labor market weakens.
If the data comes in as we expect, it will boost market expectations – and ours – that the Fed will hike only once more this year, in July, then hold rates steady for the rest of 2023.
