Beware the Inflation Head Fake
What You Missed
Last week’s data indicated that the US economy’s vulnerabilities are growing. Q3 saw banks continue to tighten their credit purse strings as interest rates rose and consumer demand deteriorated. The University of Michigan’s sentiment survey revealed mounting consumer anxiety over rising costs and a cooling job market, as jobless claims showed that unemployment levels are persisting. All told, America’s economy is facing increasing headwinds as 2023 draws to a close. The question now is if things will deteriorate enough for the powers-that-be to call a formal recession. Despite the abrupt turn in the mood music in recent weeks it’s looking increasingly likely the official arbiter of US recessions, the National Bureau of Economic Research, won’t call one, allowing the Fed to keep interest rates higher for longer, pushing any possibility of a rate cut in to late Q2 2024 at the earliest.
Curious where rates are headed through year’s end? Watch our Q4 Interest Rate Outlook livestream, recorded Thursday, October 5th. Click here or email email@example.com
Running the Numbers: Rates Higher Amid Inflation Threat
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Fed officials have consistently emphasized that they are not in a hurry to cut interest rates, with their primary focus being on tackling inflation. This emphasis will be particularly relevant on Tuesday, when markets anticipate that inflation slowed to 3.3% annually in October, down from 3.7% in September.
However, during a recent statement, Fed Chair Powell acknowledged that inflation data has been deceptive, and the central bank will continue to proceed with caution, expressing concern about the risk of misinterpreting data based on a few positive months. This cautious tone led traders to adjust their expectations for the first potential Fed rate cut, pushing it from June 2024 to July 2024. As a result, the two-year Treasury yield, which is sensitive to monetary policy changes, rose above 5%.
Although yields overall have declined from their highs seen last month, the market remains volatile. For instance, there was a sharp jump in yields following an unusually weak demand at the US Treasury’s 30-year bond auction last Thursday.
For the week:
2-year Treasury yield: up 14 basis points to 5.07%
5-year Treasury yield: up 11 basis points to 4.71%
10-year Treasury yield: up 4 basis points to 4.68%
30-year Treasury yield: down 2 basis points to 4.79%
1-month Term SOFR: flat at 5.32%
Where will SOFR be a year from now? 3-month (CME) Term SOFR, a useful gauge of hedging costs, rose one basis point to 5.38%. The implied yield on the 3-month SOFR futures contract 1-year forward (September ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, rose 14 basis points week-over-week, to 4.88%, reflecting the view that restrictive longer-term yields may be substituting for additional Fed rate hikes.
How much higher will SOFR rise? 1-month SOFR, via the SOFR forward curve, is expected to peak at 5.40% in February 2024, then decline consistently over the next year as the Fed eventually cuts interest rates in Q2 2024.
Will rate cap costs ever decline? Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, fell to levels last seen in late September. Any sharp fall in rate volatility, like that seen over the last week, helps to drive rate cap costs lower. However, until there are clear signs that the Fed is on a rate cutting tilt, rate cap costs won’t decline precipitously. Curious what a rate cap costs? Check out our rate cap calculator.
Elsewhere, equities were little changed in the week. The price of a barrel of West Texas Intermediate crude oil fell $3.55 to $77.33 from $80.82 a week ago, as the US dollar strengthened, and Gold weakened.
Bank Loan Officer Survey Implies that More Pain Lies in Wait
Last week’s release of the Senior Loan Officer Opinion Survey (SLOOS), a measure of the standards and terms of bank lending practices, the state of business and household demand for loans among other topics, showed that banks continued to tighten commercial credit in the US through October, though the pace of that tightening surprisingly slowed.
While encouraging on the surface, the report also showed one potential source of economic resilience now on the retreat: Consumer demand for credit and small business demand for commercial and industrial loans continued deteriorating as interest rates rose throughout Q3.
Our take: The SLOOS survey is worrisome. In Q3, the robustness of personal spending was the main driver of positive, upside surprises in US economic activity. However, the growing reluctance of consumers to depend on credit to sustain their spending patterns, coupled with sluggish wage growth, reduced hiring, and diminishing excess savings, doesn’t bode well for the almighty US consumer, who alone drives ~70% of America’s economic activity, and thus diminishes growth prospects for Q4 and into 2024. Given the tightening of lending standards by banks and the waning consumer demand, it is unlikely that bank credit will act as a pillar of economic resilience.
Sentiment Survey Shows Consumer Anxiety is Growing
The University of Michigan’s consumer sentiment survey for November – a monthly survey of how consumers feel about the economy, personal finances, business conditions, and buying conditions – dropped to 60.4 in November’s preliminary report from 63.8 prior, below the consensus expectation of 63.7.
Peeling back the layers, the survey revealed that consumers expect persistent and even higher inflation in the near term, exactly what the Fed hopes to avoid. Coupled with elevated borrowing costs and weakness in the job market, this suggests that the economy is losing steam following the exceptionally robust growth observed in Q3.
Our take: It’s increasingly clear that the consumer’s willingness to spend is becoming constrained, which makes sense considering the weaker than expected October jobs report showing a rising unemployment rate and slower wage growth. Throw in a sustained rise in applications for jobless benefits and you’d be justified to think that the current 3.9% unemployment rate will rise further through year-end. Given that the unemployment rate is projected to exceed the Fed’s Q4 forecast of 3.8%, that tells us that the Fed will hold rates steady through the rest of the year.
Multiple Signals Imply that a Recession is Around the Corner – But Is it Different this Time?
No economic indicator is more useful for identifying a recession than unemployment. Over the past 70 years, a consistent pattern in business cycles has emerged: when the unemployment rate surpasses a specific threshold, it tends to rise significantly beyond it as the economy plunges into a recession. Various indicators now indicate that the US jobs market is approaching or may have already exceeded this critical threshold. However, the unprecedented pandemic introduces a unique twist to this business cycle. This prompts us to wonder: Could this time be different?
Before we contemplate that question, it’s helpful to know who officially calls a recession. The National Bureau of Economic Research (NBER) is the organization responsible for officially determining the onset and end of recessions in the US. Within the NBER, the Business Cycle Dating Committee comprises experts who analyze various economic indicators to make these determinations. They look beyond the simplistic rule of two consecutive quarters of negative gross domestic product (GDP) growth and consider factors such as nonfarm payrolls, industrial production, and retail sales. Importantly, their assessments are retrospective, meaning they declare a recession after it has already occurred, rather than predicting it in real-time. Thus, when it comes to officially identifying a recession, it’s the NBER that calls it, but their call of such isn’t all that useful.
So, is it different this time? To answer that question, it is best to use tried and true rules that have been helpful in the past. The national unemployment rate’s three-month moving average (U3) is now 0.42 percentage points higher than its low over the last year. That is large enough to have predicted all 11 recessions since 1950 in an average of three months from their start, using the Sahm Rule . The rule states that the start of a recession is imminent when U3 rises by 0.50% or more relative to its low during the previous 12 months and has a false positive rate of just 1%. While the unemployment rate hasn’t hit the rule’s 0.50% just yet – it was 0.42% in October – if the unemployment rate remains at 3.9% in November and December, the Sahm rule’s 0.50% threshold would be hit in December. Will we soon be in a recession? You can watch the odds real-time here.
Our take: Our view remains that this time isn’t different, and that we’re likely on the verge of a shallow recession if we’re not in one already. However, the unique characteristics of this business cycle, coupled with the Fed’s efforts to combat inflation, introduce more uncertainty than historical recession rules would suggest.
In the current scenario, there are two significant risks to avoiding a recession which the National Bureau of Economic Research (NBER) does not explicitly address: geopolitical factors and credit-related concerns.
While we won’t delve into this extensively, it’s essential to recognize that unexpected escalations in global hostilities could significantly impact market sentiment and potentially push the US into a recession. Outside of geo-politics, t he most critical internal risk facing both the economy and the market is credit. Bankruptcy filings and charge-off rates are on the rise, indicating underlying stress that isn’t fully reflected in credit spreads. Additionally, the opacity in rapidly growing private-credit markets is becoming a growing concern. Monitoring credit closely is crucial, as any rapid deterioration could swiftly tip the economy into recession territory.
What to Watch: All Eyes on Inflation
In his speech after the last Fed policy meeting on November 9th, Fed Chair Powell reiterated a notion that the Fed has attempted to brand on all our brains: the process of bringing inflation sustainably down to 2% – the Fed’s official inflation target – still has a long way to go, and that more rate hikes are still on the table.
From our perspective, Fed officials are likely to maintain a tightening bias until the monthly core Consumer Price Index (CPI) – the Fed’s favorite inflation gauge – shows a consistent pace of 0.2% to 0.3% for at least six months. While the lower end of this range was only seen briefly in the summer, core CPI, which the Fed really cares about, has been inching toward the upper end. This inflation trajectory aligns more with an annual inflation rate of 3% rather than the Fed’s 2% target, thus keeping the threat of another Fed rate hike alive.
We expect October headline CPI (released Tuesday) to have risen just 0.1% (vs. 0.4%) month on month, and 3.3% year on year (vs. 3.7%), due to declining global energy prices. If we’re correct, the year-over-year change for CPI will still be at 4.1%, far higher than the Fed’s 2% target. For context, to get CPI anywhere close to 2%, monthly core CPI needs to run at about a 0.2% pace for an entire year. Considering where month-over-month CPI is now, 0.4%, that’s a stretch, and it makes sense that the Fed continues to express a lack of confidence that rates are high enough to ultimately smother inflation. It tells us that the Fed will continue to shout from the rooftops that another rate hike is on the table.
Flipping over to the Fed’s other mandate, jobs, the average Fed voting member predicts – via the Fed’s Summary of Economic Projections – that the unemployment rate will peak at just 4.1% in 2024, and they anticipate avoiding a recession. However, the market consensus is for unemployment to peak next year at a much higher 4.4%.
For guidance on whose prediction for unemployment is right – the Fed’s or the market’s – we look to small businesses, who alone account for about half of US employment. Only 17% of small businesses (according to the National Federation of Independent Business, releasing their most recent survey on Tuesday) have plans to create new jobs in the next three months. With job growth slowing, the time the unemployed stay that way is expected to rise (continuing job claims, Thursday). Even without mass layoffs, the unemployment rate is likely to climb persistently.
All told, the challenge of finding employment will eventually dampen consumer confidence, leading to reduced spending and a Fed that stays on the sidelines – despite the constant threat of inflation – for the rest of the year and into early 2024.
Our colleague Rex Evans is at the IMN Multifamily forum in Arizona on Monday, November 13th. He’s easy to spot because he’ll be wearing a Panama Hat. Looking to lower cap premium costs? Give him a call/text 415-235-7202 or email firstname.lastname@example.org.
Extending a Rate Cap? Smart Borrowers are Doing This Now
A huge dilemma exists for borrowers who financed their asset via a bridge loan, bought a required interest rate cap at a low strike at closing, and are now confronted with the need to extend that rate cap for another year or two.
When rates were ultra-low, a 2.00% cap on $20mm might have cost $50k and many borrowers opted to buy a 2-year cap on a loan with a 3-year term. The expectation at the time was that the asset would be sold or refinanced early at more favorable terms, or the borrower simply didn’t see the logic in buying a 3-yrear rate cap at loan close. Or – the mostly common occurrence – the borrower never expected they would have to ask for a loan extension. Now, the borrower is faced with the requirement of extending the rate cap, at an eye-watering cost in the hundreds of thousands.
A client called us recently asking how borrowers are dealing with the unexpected costs and whether lenders are willing to accept amendments to the initial rate cap requirements. The first step, and the most important one, is to engage your lender well in advance. Waiting until the last minute significantly reduces your ability to negotiate.
Using the example above, we can provide the analysis that a 4.00% strike offers approximately the same interest rate protection as a 2.00% strike and does so at a much lower cost. A 4.00% strike for one-year costs $285,000 and a 2.00% cap costs $700k. Both strikes synthetically fix the loan. The catch? In both cases, you are pre-paying interest, and synthetically lowering the interest rate on a loan by buying down the points. The interest expense for each accrual period with a 2.00% cap is going to be lower than a 4.00% strike. The difference? The cost of extending the rate cap.
Depending on the performance of the asset, some lenders may be amenable to the higher strike once they understand the economics, but they aren’t going to do the analysis for the borrower. Some lenders are willing to waive the cap requirement altogether or even accept an interest reserve fund in lieu of an extended rate cap. Give us a call 415-510-2100 to discuss your particular situation.