Beware Inflation’s False Dawn

What You Missed

News of a fall in the Fed’s favorite inflation gauge – the core PCE Deflator – provided yet another sign that the Fed’s 525 basis points in rate hikes are having their intended impact at slowly but steadily squashing inflation.  Layer on other emerging signals of a steadily weakening jobs market and a slowing economy, and we’ll eventually have all the ingredients needed for the first Fed rate cut. The fly in the rose’?  Those ingredients won’t coalesce enough to prompt the Fed to cut until December at the earliest.

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Running the Numbers: Rates Leap Higher on Quarter-End Rebalancing

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Treasury yields climbed steadily, capping off a week characterized by accelerating inflation overseas, fireworks in the currency market, and news that the core-PCE deflator posted an expected decline. While the PCE data indicated progress on the Fed’s inflation fight – which would typically cause Treasury yields to fall – bond yields rose, and there was little reaction in Fed pricing in the aftermath mainly due to quarter- and month-end rebalancing of bond trader’s books.

Despite last week’s surge in yields, the 10-year Treasury yield is still down twelve basis points in June after an 18-basis-point drop in May.  Since the middle of June though, the 10-year has struggled to break below 4.2%, even amid minor signs of a softening jobs market and weakening inflation pressures. It’s stuck mostly because Fed officials continue to say they need to gain more confidence in the inflation outlook before seriously considering cutting interest rates.

The dynamic has created a floor under longer-term interest rates, like the 10 and 30-year Treasury yields, limiting just how far they can fall. It’s also clear that the Fed Funds rate, which currently sits at 5.50%, hasn’t proven as restrictive on economic activity as the Fed had hoped. It’s an argument we’ve been making for months now and is evidenced by the Fed’s own gauge that financial conditions are nowhere near restrictive but are quite loose. We explored this concept in detail during our Q3 Interest Rate Forecast webinar last week. Download the slide deck and watch the replay HERE.

For the week:

Where will SOFR be a year from now? 3-month (CME) Term SOFR, a valuable gauge for the true cost of interest rate hedging, fell one basis point to 5.32%. The implied yield on the 3-month SOFR futures contract 1-year forward (June ‘25), an estimate of where markets expect 3-month Term SOFR – and by extension, hedging costs – to be a year from now, rose eight basis points week-over-week to 4.35%, reflecting higher Treasury yields and the view that there’s no real hope for a near-term Fed rate cut.

When will SOFR Fall? 1-month SOFR, via the SOFR forward curve, implies that one-month SOFR has peaked near 5.33% and will decline precipitously over the next year as the Fed eventually cuts interest rates in early 2025. The forward curve projects that 30 Day SOFR will steadily decline from here, eventually bottoming out near 3.48% in March 2028, up two basis points from this time last week.

Where is the 10-year Treasury yield headed? The 10-year Treasury forward yield curve implies the yield will bottom out at 4.14% in June 2025 and then stage a slow and steady sequential rise. With all the US Treasury’s debt issuance on tap in the coming quarters and a seemingly resolute Fed, it’s tough to imagine a 10-year Treasury yield sustainably below 4.20%.

While the forward curves for SOFR and Treasury yields aren’t forecasts – they’ve proven to be a horrible predictor historically – they give one a peak at the market’s current thinking.  Given the narrow trading range expectations for the 10-year Treasury, expect the front end of the curve to drop getting us back to a more normal sloping yield curve.

When will rate cap costs decline? Rate volatility, a vital driver of the cost of option-based interest rate hedges like rate caps, fell to a one-week high. Rate cap costs continue to hover 25-30% below their peaks and will likely continue their slow, downward path as the road toward the Fed’s first rate cut gets shorter.

Are you curious about what a rate cap costs? Check out our rate cap calculator. The calculator is a valuable tool for providing an estimate, but if the expected start date is a couple of months away or the cap’s notional amount is amortizing/accreting, give us a call at 415-510-2100 for indicative pricing based upon the specific economics.  Cap costs can vary widely – as much as 40% – when considering changes in the notional schedule or “step-up” strike structures.

Elsewhere, equities were modestly higher on the week with the S&P 500 trading at a fresh intraday record on Friday morning. A barrel of West Texas Intermediate crude oil edged up $0.09 to $81.73 as the US Dollar strengthened and Gold weakened.

The latest Read on Inflation Gives Some Relief to the Fed, But it Won’t Last

The headline Personal Consumption Index (PCE), a measure of consumer spending and a leading economic indicator on the health of the economy, registered 0.0% in May (versus +0.3% in June), in line with the expectations.

The core PCE deflator, which excludes historically volatile food and energy prices and is the Fed’s preferred inflation measure, slowed to 0.08% month-over-month (compared to 0.3% in April). Year-over-year, core PCE inflation fell to 2.6% (versus April’s 2.8%), marking its lowest reading since March 2021.

Going deeper, “supercore” PCE inflation, Fed Chair Jerome Powell’s preferred inflation gauge, increased to 0.1%. The three-month annualized rate eased to 3.3% (vs. 3.6% prior), with the six-month annualized rate at 4.1% (vs. an upwardly revised 4.2%).

What it all means: Both the headline and core PCE inflation rates for the month of May registered their lowest levels so far this year. This was primarily because the price of gasoline continued to fall, as well as prices for durable goods. That’s the good news. The bad news is that prices for services – toward which much of consumer spending has shifted this year – are expected to remain high and, as such, boost inflation in the second half of the year. The dynamic calls into question whether inflation pressures will mellow enough this year to give the Fed confidence that a rate cut is warranted. Add in news that personal incomes grew 0.5% in May, up from 0.3% in April, and you can see how we’re skeptical inflation can fall enough in the coming months to justify a rate cut.

If inflation doesn’t fall enough to justify a cut, that puts the burden on the Fed’s other mandate to get us there: jobs.

What to Watch: Jobs Data Won’t Make Your Rate Cut Dreams Come True

The Fed should feel self-assured that its 525 basis points in rate hikes are slowly but surely having their intended result. Consumer spending has slowed, as have inflation pressures, while spending on goods – versus services – continues to trend lower. Data dependency continues to be the Fed’s main mantra, and the coming week’s data should provide more evidence that rate hikes are working – but are doing so more slowly than the Fed would like.

While that’s all nice and good, June’s jobs report (Friday), which we expect to provide news of a still-robust jobs market, won’t provide the needed impetus for the Fed to seriously consider changing its stance on interest rates, especially since the inflation side of the Fed’s dual mandate isn’t cooperating.  We expect that ~150k in new jobs were created in the month, with interest rate-resistant sectors of the economy – like healthcare – providing most of the juice.  Leisure and hospitality, which has absorbed many low-skilled immigrants, likely boosted the number. The unemployment rate likely remained unchanged at 4%, with wage growth posting a respectable gain. It’s your classic “good news is bad news” scenario, where everyone likes to see jobs being created and Americans fully employed, but they don’t like what it means for rate cuts: delayed until late 2024 at the soonest.

Elsewhere, minutes from the Fed’s last meeting on June 12th (Wednesday) will clarify how members view the evolving balance of risks. The ISM manufacturing index (Monday) and the JOLTS job openings report (Tuesday) will also help indicate the near-term direction of the economy. Outside of data, there are a few speaking engagements from Fed officials this week, including Fed Chair Powell (Tuesday) and New York Fed President Williams (Wednesday and Friday).

Three Surprise Risks for the Second Half of 2024

While all eyes and ears continue to be on the Fed’s rate-cutting path, there are a handful of risks that lie in wait for the direction of interest rates:

  • Those who provide credit expect almost zero chance of interest rates being truly higher for longer from here. If a negative catalyst causes a credit crisis, even a short one, it will impact the real economy.
  • No expects inflation to reaccelerate. If it does, few assets – stocks and Treasury bonds specifically – reflect any significant protection against a scenario in which the Fed and other central banks resume hiking interest rates.
  • The “Goldilocks” economy we’re all living in – where the Fed’s 525 basis points of rate hikes have slowly cooled inflation without wrecking the jobs market or the US economy – is a fragile one. Should economic growth slow markedly without an ensuing fall in inflation, the situation could morph into stagflation quickly.

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