A Slower Pace To A Higher Peak

2022 Derivative Logic, Inc.

What You Missed

Yields across the spectrum rose to new multiyear highs again last week, after the Fed hiked the Fed Funds rate by 75 basis points and threw cold water on the notion that it is contemplating a dovish pivot.

For the week, the 2, 5, 10 and 30-year US Treasury yields added a respective 17, 10, 12 and 15 bps. The surge in yields reflects a continued, slow but sure capitulation by markets that the Fed may not ease off aggressive rate hikes as soon as many had hoped. The large jump in yields in long dated maturities in particular – specifically the 10- and 30-year – reflects the near breaking-point strain that the Fed’s sizable rate hikes to date and expectations of more are having on governments and economies around the world.

Elsewhere, the price of a barrel of West Texas Intermediate crude oil climbed to $92 from $88.15, while the US Dollar weakened, and Gold strengthened. The US 2-year vs. 10-year Treasury yield spread, a widely watched barometer of the likelihood of a looming recession, touched -0.59% last Thursday, its most inverted level since 1982. To learn more about yield curves and what they tell us about the future interest rate landscape, click the link.

Hedging Costs Eased Somewhat But Remain High

3-month (CME) Term SOFR, a useful gauge of hedging costs, continued its relentless ascent, rising ~10 bps last week to 4.21%, yet another new high for the three-year old index. The implied yield on the 3m SOFR futures contract 1-year forward (December ‘23) rose four basis points from this time last week to 5.11%. The SOFR futures markets continue to imply that markets expect that 3-month SOFR will peak in March or April of next year – along with the Fed Funds rate – followed by a gradual decline over the next three years as the Fed eventually eases. Finally, interest rate volatility, a key driver of the cost of rate caps, eased to levels last seen in mid-September, after logging a post-COVID high on October 13^th.

Fed Gave markets the Cold Shoulder

As recently as a week ago, rates markets started to sense that the world’s central banks were downshifting to a lower gear after frontloading a series aggressive rate hikes throughout the year. That sixth sense has largely shown to be accurate, with one glaring exception: The Fed. While the Reserve Bank of Australia, Bank of Canada, and Bank of England have all started to hike rates in smaller chunks (or, in the case of the BOE, indicate that it likely will), the Fed warned that while it may hike in smaller increments after its next meeting or two, its peak Fed Funds rate will likely be higher than what was anticipated in September, when the Fed last released its forecasts. In last Wednesday’s post-meeting press conference, Fed Chair Powell went out of his way to emphasize that it is “extremely premature” to discuss any pause in the Fed’s hiking cycle and that he sees the risk of not tightening enough (and letting inflation become entrenched) far outweighs the risk of tightening too much.

Of particular interest to commerical real estate, Fed Chair Powell also downplayed the idea that the Fed is overemphasizing backward-looking measures of rental inflation when deciding its policy path, despite the fact that more forward-looking measures have been rolling over. It’s important beacuse rental inflation is the biggest driver of overall inflation and will probably be a leading factor in determing the Fed’s course on interest rates over the next year or two.

Our take: The Fed’s re-writing of its expected policy trajectory has been a regular feature of the landscape this year, and reflects a clear change in bias from the easy-money Fed we’ve all grown to know and love for the past several decades. It’s a tough pill to swallow for borrowers and lenders who’ve only known an easy-money world.

The Fed has now hiked rates a total of 375 basis points this year to slow growth and stamp out inflation. The problem is, neither one of those has happened. In acknowledgement of that, the Fed Chair said teh Fed has a “ways to go” to get interest rates to a sufficiently restrictive level. That tells us to be increasingly skeptical of a LIBOR or SOFR forward curve that impies we’ll see a series of significant rate cuts next year. Those that have sat through our “Hedging 101” lunch and learns know that forward curves turn out to be a very poor predictor of where rates are headed, and we expect that dynamic to hold this time around.

Data Sent Mixed Signals on the State of the Jobs Market

One job survey suggested significant job growth while another showed an increase in unemployment. Headline nonfarm payrolls – a reflection of the state of hiring as seen by businesses – increased by 261k in October (vs. 315k in September) extending the slowdown from the 500k in monthly job gains seen early this year. A net revision of the data for the prior two months showed hiring was 29k higher than previously thought. However, the household survey – data obtained from querying households – painted a very different picture. Employment fell by 328k (vs. 204k prior), while unemployment rose by 306k (vs. a drop of 261k prior). That pushed the unemployment rate up to 3.7%, from 3.5%, higher than what was expected. For some perspective, it is said that the number of jobs needed to be created each month to maintain the job marker’s heady temperature is a mere 35k, due to the slow increase in the working age population and the Baby Boom generation’s steady retirement.

Other segments of the data showed that the growth in wages continued last month, putting upward pressure on inflation, rising 0.4%, above the expected 0.3%. Taking into account other wage gauges, like the Fed-preferred Employment Cost Index and the Atlanta Fed’s wage tracker, the upward momentum in wages is confirmed, and is probably much higher, and running at a higher pace than where the Fed would prefer.

Our take: When adding other important jobs data into the mix, such as the still-high number of job openings and strong wage growth, it’s clear that the strong jobs market isn’t cooling off fast enough to prevent the Fed from hiking its Fed Funds rate to at least 5.00% – its 4.00% now – by the spring. That means that we’re headed for another 100 basis points in hikes between now and then. However, when taken together, the murkiness in the jobs data also gives the Fed optionality to downshift its hikes to 50 basis points, down from 75, beginning at its next meeting on December 14^th. As rate hikes continue to be felt through the economy, we suspect that the unemployment rate will steadily creep higher through 2023 and the US economy tips into recession. If you don’t remember anything you’re reading here, remember this: The Fed will keep hiking until the strong jobs market breaks.

What to Watch This Week – Latest inflation gauge on the dance card

Markets are slowly getting the message that the Fed means business. Fed funds futures markets, where investors can express their view on how high the Fed Funds rate will go, now see a peak of 5.25% in mid-2023. In between now and then, five Fed policy meetings lie in wait: December 2022, January 2023, March, May, and June. Before the December meeting rolls around, we’ll get three sets of impactful economic data that will help drive the Fed’s decision on how much to hike; two inflation and one jobs-market report.

This Thursday’s latest read in inflation (Consumer Price Index, aka “CPI”) will give us the first clue. The core inflation reading should, on the surface, give the Fed some encouraging inflation news, as price pressures for essential products and services have likely eased. Unfortunately, any slowing will still leave inflation far higher than the Fed’s 2% inflation target. As prices for goods continue to decline, they’ll be mostly offset by stubbornly high inflation in services, led by rents. Relevant to our readers in commercial real estate, Owner-equivalent rents, a significant driver of overall inflation, aren’t expected to peak until the first half of 2023.

Big Picture – Want to know what the Fed will do next? Watch jobs.

With consumers continuing to spend and trade being boosted by energy demand, the economy is on course to record positive growth this quarter. The billion-dollar question now: For how long?

Consumer demand, as measured through high-frequency indicators like retail sales and airport traffic, appears to be downshifting but not collapsing. Data on consumer-spending, the lifeblood of America’s economy, are in line with sub-2% growth in the months ahead, with spending set to downshift even more next year as rate hikes bite further. Elsewhere, other high-frequency data paint a murky picture. With rising energy demand, the number of crude oil rigs is gradually increasing, which is helping exports. Conversely, amid waning demand, steel production is treading downward.

Even while there are some signals of cooling, the jobs market is still a shining light. Initial unemployment claims are at historically low levels, and employers are still reluctant to fire employees after being stung by labor shortages during the pandemic. Any news of layoffs is dispersed and limited to a few industries that made significant hiring during COVID.

The shining jobs market begs another question: how bad must unemployment become before inflation cools to the Fed’s 2% inflation target? The unemployment rate is no lower today than before the pandemic, yet the difference in inflation in the pre-versus-post pandemic period is dramatic. Economic models are having a hard time explaining why. One answer? The ratio of the number of open job vacancies looking for a worker to fill them, versus the number of unemployed. Normally, there’s an inverse relationship between the two: When the jobs market weakens, firms scale back their hiring plans, which results in fewer job openings, and unemployment rises because more people are unable to find work. When the jobs market strengthens, traditionally just the opposite is true.

But this ratio isn’t 1:1. During the past seventy years, every time job vacancies declined from a peak, unemployment increased substantially, and much more so than the decline in job vacancies. At present, this ratio between job vacancies and the unemployment rate – called the Beveridge curve – is showing the highest reading in its 70-year history, and tells us that, to cool inflation, the Fed will have to bring down the number of open positions as a key part of its inflation fight. How will it do that? By doing its best to increase the unemployment rate substantially, to somewhere near 4.5% (it’s just 3.7% now) which equates to around 1M in job losses between now and when the Fed can claim “Mission Accomplished”. With another 200k or so in new jobs likely to be added to payrolls this month, exactly what the Fed doesn’t want, we’ll need to see job losses average 100k or so each month over the next year to get anywhere near a 4.5% unemployment rate.

Bottom line? If smothering inflation is the Fed’s number one focus, it must also smother job creation in the process. It will likely broadcast this intent via the publishing its next round of economic forecasts in December, by revising down its forecast for the unemployment rate and revising up its inflation forecast, which, in summation, means raising its forecast of where the Fed Funds rate will peak, likely well above the current 4.88%.

Always speak to an independent advisor to discuss a strategy that makes sense before terminating a swap.

The team was in Los Angeles a couple of weeks back at a multi-family commercial real estate conference, and interest rate caps were top of mind. We were asked multiple times how to protect against higher rate cap costs in a rising rate environment for borrowers who expected to have to extend their rate cap – with a strike well below current market rates – in conjunction with an extension of a loan. Some Lenders are telling borrowers they need to extend their caps at the original strikes well before the cap is set to mature, often to the detriment of the borrower. We’ve had success providing analysis to help the borrower realize the best of both worlds: 1) To structure the cap extension in a way that reduces its cost, and 2) Is acceptable to the lender. In this common scenario, engaging an independent derivative advisor with extensive capital markets experience is critical. Put our decades of experience to work for you.

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