Bank Earnings Key to Near Term Rate Path
Click below to listen to this week’s edition of Straight to Smart
What You Missed
The interest rate state-of-play at present is one that finds the Fed still intent on fighting inflation that’s too high for its comfort, amid a moderating but still robust average consumer. The Fed’s resolve to keep hiking was supported by the first strong reading of bank earnings late last week, enabling it to justify a higher-for-longer rate stance as the economy likely drifts into a mild recession later this year.
After a calm start to the week, inflation data mid-week drove yields across the maturity spectrum higher. For the week, the 2, 5, 10 and 30-year Treasury yields rose 16, 14, 14 and 14 basis points, respectively. The rise in short-term yields released some pressure in the 2s-10s yield spread, a widely watched barometer of looming recession, to -61 basis points, well off its most inverted level (-108) since the 1980’s, briefly seen a couple of weeks ago. Swap rates on 3-, 5-, and 10- year maturities are each now at least ~54 basis points below their Q1 cycle highs, meaning fixed rate financing, if available, is on discount.
Elsewhere, global equities were higher on the week amid solid early Q1 earnings reports. The price of a barrel of West Texas Intermediate crude oil added $2.50 to reach $83, while the US Dollar weakened, and Gold strengthened.
**Borrrowers: Have you received a notice, like this one from your rate cap bank asking you to contact them to address the LIBOR transition? Contact us before you respond, as making the wrong decision will cost you money.**
Hedging Costs Fall in Lockstep with Lower Rate Volatility
3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, made up lost ground to trade at 5.03%, shy of its all-time high near 5.12% hit back on March 10th. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, rose 17 basis points week over week, to 4.03%, reflecting the growing view that the Fed isn’t done with rate hikes just yet. Swaps markets are pricing around 60 basis points in rate cuts before the end of the year, implying a credit contraction or recession will start to bite over the summer.
The SOFR futures market, and the forward curve it projects to the world, implies that 3-month SOFR will peak at 5.07% sometime in June, and expects it to decline over the next year as the Fed eventually eases.
Finally, interest rate volatility, a key driver of the cost of interest rate caps, continued its rapid decline from eye-watering levels seen last month. Should rate volatility continue its calming trend, expect rate cap costs to also track lower assuming the yield curve stays depressed.
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.
Confused or uncertain about how the transition will impact you? Give us a call, 415 510-2100, to help guide you through it with as little damage to your bottom line as possible. Make no mistake, making the wrong decision will cost you money.
Sticky Shelter Inflation Keeps the Fed on a Hiking Path
Last week’s highly anticipated reading on the state of inflation, via the Consumer Price Index (CPI), showed a softening in inflation pressures, giving the Fed some breathing room in its months-long inflation fight.
Headline CPI increased by 0.1% in March, down from 0.4% in February, and lower than the 0.2% expected. Core prices rose 0.4% month on month and 5.6% in year-on-year terms, compared to 0.5% and 5.5%, respectively, in February. Since January 2021, year-over-year core inflation hasn’t been higher than the headline reading until now, suggesting the Fed will need to keep rates higher for longer to sustainably rein in inflation.
Inflation in core services rose by 0.4% in March, and the annual rate of 7.1% was the lowest since December. The increase in core services came mainly from shelter prices, which rose 0.6% over the month and 8.2% over the past year. Rents and owners’ equivalents of rents (OER) both rose 0.5% month on month – down from 0.8% and 0.7%, respectively, in February – to a pace last seen in April 2022.
Finally, inflation in the Fed’s favorite subset of inflation data – core services ex-housing, aka “supercore” inflation – remains elevated at 5.8% year-over-year. The figures show that labor-intensive service industries continue to face pricing pressures, suggesting that the Fed will need to cool the hot jobs market further to bring inflation under control.
Bottom line: Like we stated in last week’s Straight-To-Smart, don’t be fooled by the softening inflation data. The Fed will feel little lasting relief with headline CPI inflation coming in only slightly below estimates. Persistently high core prices demonstrate inflation’s stickiness, and recent oil production cuts by OPEC and its allies equate to high and rising gas prices, which are showing up just as the spring/summer driving season begins. All told, the good news on headline inflation is only temporary, keeping the Fed’s finger on the trigger for at least one more 25-basis point rate hike, on May 3rd.
Retail Sales Data Highlight an Increasingly Discerning Consumer
Consumers, who alone are responsible for 75% of America’s economic output, are seemingly becoming more selective in their buying choices as evidenced by the March retail sales data, which showed a widespread decline in activity. US retail sales fell by a more than expected, 1% month over month in March, while core sales, which don’t include things like food services, cars, gas, and building materials, fell by a less-than-expected 0.3%. Much of the drop was caused by falling fuel prices, but the recent recovery in oil prices portends higher gas prices in the future.
Falling sales of vehicles and parts – a spending category that’s especially sensitive to interest rates – were responsible for over one-third of the overall 1.0% decline. The recent rise in gas prices brought by the production cuts by OPEC+ leaves consumers with less money to spend elsewhere.
Our take: Consumers’ expectations that the economy will deteriorate are reflected in a second consecutive month of weak retail sales. The major proxy for services in the data, spending on food services, was almost flat in March, suggesting a decline in consumer demand for discretionary services. Rising gas prices and a probable credit crunch will put greater pressure on consumers, raising the odds of a recession later this year.
Fed Expects a Mild Recession this Year
According to the March Fed meeting minutes published this week, Fed officials just made an explicit recession prediction. They said that the repercussions from the recent SVB-inspired banking crisis will be the trigger for a recession later this year.
Central banks seldom make such predictions. The bank deposit crisis unfolded less than two weeks before the meeting, which prompted many Fed officials to shift their views on interest rates. Some pushed for a pause in rate hikes to begin as soon as the March meeting, while others who had earlier supported a 50-basis-point hike converged around 25 basis-points, a position that the Fed voting members finally accepted unanimously, resulting in a 25 basis point hike on March 22nd.
Looking ahead, the Fed implied that it will monitor the availability of credit closely for any signs of tightening, as any such event would curtail the need for more rate hikes.
Our take: The Fed meeting minutes reveal that inflation fears dominated the members’ anxieties even though the banking crisis was still fresh in their minds on March 21–22. As such, we expect the Fed to hike rates once more, then pause for several months considering the jobs market’s continued tightness, inflation’s “unacceptably high” levels, and “supercore” inflation’s scant signs of slowing.
What to Watch This Week – Housing and Bank Earnings in Focus
Supply-chain bottlenecks from the pandemic era and demand driven by the massive fiscal stimulus laid upon the economy drove US inflation to multi-decade highs. Sticky price pressures, especially in important service categories, now threaten to keep it higher than the 2% level the Fed desires.
The Federal Reserve ramped up its efforts to combat inflation last year, raising interest rates by 75 basis points at four consecutive meetings before reducing its rate hikes to a half a point in December and a quarter point in February and March.
The hikes are finally showing signs of having the impact the Fed wants. The steam is finally coming out of heady consumer prices, but core inflation is still resilient. Although there is strong hiring, salary growth has slowed. It’s all setting up a dicey scenario for the Fed to stick a soft economic landing, with a mild recession looking increasingly likely in Q3. This week’s data will demonstrate how much the current quick tightening is already affecting both housing and overall economic production.
The slew of housing data on tap – the NAHB on Monday, housing starts on Tuesday, and existing home sales on Thursday – are expected to show continued weakness. Even though mortgage rates and interest rates in general fell in March because of the mini banking crises, the typical homebuying family shops at the lower end of the housing market, which will keep sales volumes low. The transition from single-family homes to multifamily housing has been the saving grace for sales volumes, a trend that will likely be confirmed in the data.
As they assess the potential hit to economic growth from any slide in lending, the Fed and markets will be monitoring comments on lending plans and expectations for deposit costs closely as banks continue to report earnings throughout the week. How well markets withstand the typical post-earnings surge of bond sales from banks is another factor under consideration. Although the instability in the banking sector now looks to be under control, the Fed believes it will eventually lead to tighter credit conditions and is on high alert for any signals of such.
Elsewhere, the individual tax-date deadline of April 18 will also give markets information into government cash flows and how long the US Treasury can continue to use exceptional measures to keep under the debt ceiling. The X-date for lifting the debt ceiling is anticipated to be in the middle of August, although that might change depending on tax receipts. House Speaker Kevin McCarthy is expected to announce a plan to raise the debt ceiling for a year next week.
Do you think the Fed is going to raise rates more than expectations or keep rates at current levels into 2025? Whatever your opinion, an interest rate swap can be structured to mitigate risk, views, and market exposure. Call us to discuss how swaps can help you manage interest rate risk. Curious? Reach out to us.
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Source for all: Bloomberg Professional