Blowout Jobs Wash Away March Rate Cut
What You Missed
Fed Chairman Jerome Powell shocked the world following last Wednesday’s Fed rate-setting meeting, explicitly stating that a rate cut in March was unlikely. Layer in last Friday’s release of the blockbuster January jobs report – which showed a whopping 353k new jobs were created in the month – and you have a scenario where Wall Street economists scrapped the last of their projections for a March rate cut, now opting for the month we’ve been predicting for weeks now: May.
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Running the Numbers: Rates Higher as March Rate Cut Bets Collapse
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Investors’ confidence that the Fed will execute a series of interest rate cuts this year is being put to the test by the surprisingly resilient US economy. The central bank is under no immediate pressure to begin easing monetary policy, as evidenced by the surprise spike in hiring in January. This gives it even more time to assess whether inflation is steadily approaching its 2% target and implies that your hopes of a near-term interest rate cut are misplaced. However, everyone agrees that as the post-pandemic surge continues to fade, the Fed will have to cut rates at some point this year, and the debate is now focused not necessarily on when, but how much the Fed will cut over time.
In the meantime, there is a ceiling of sorts being established in Treasury yields by the persistent belief that the Fed will begin to cut rates by the middle of the year at the latest. Whenever yields have spiked, buyers of Treasuries have consistently pounced, seeking to lock in the relatively high yields before they vanish, and in doing so, driving yields lower (remember the inverse relationship between yields and price). In addition, a record-breaking $6 trillion is being held in money market funds; if short-term rates begin to decline, as they will once the markets smell a looming Fed rate cut, these funds will begin to flow toward bonds, exacerbating an overall fall in yields.
For the week:
Where will SOFR be a year from now? 3-month (CME) Term SOFR, a more useful gauge of hedging costs than 1-month Term SOFR, held steady at 5.31%. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘25), an estimate of where markets expect 3-month Term SOFR to be a year from now, rose twenty-two basis points week-over-week, to 3.86%, reflecting the u-turn by markets on the liklihood of a March rate cut.
How much higher will SOFR rise? 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 several times throughout 2024. The forward curve projects that 1-month Term SOFR will steadily decline from here on out, eventually bottoming out near 3.29% in February 2026.
When will rate cap costs decline? Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, fell once again week over week. Curious what a rate cap costs? Check out our rate cap calculator.
Elsewhere, equities were higher on the week amid solid earnings reports from several megacap tech companies. The price of a barrel of West Texas Intermediate crude oil fell $4.65 from this time last week to $72.17. The US dollar weakened and Gold strengthened.
Fed Pushes Back on March Rate Cut
The Fed rarely makes significant changes to the wording of its policy statement – the official publication released during its scheduled rate setting meetings that states its decision and the reasons why it made it – from meeting to meeting, but the January statement from last week’s meeting is a sea of red, strongly indicating a clear shift in the Fed’s position on interest rates.
While we won’t bore you with the line-by-line changes, know that the statement from last week’s meeting now suggests the Fed has officially moved from a hiking to a neutral stance on interest rates, implying that it’s done with rate hikes, but also is rejecting the widely held notion (but not by us) that interest rate cuts are happening as soon as March. Blend in Fed Chair Powell’s admission during the post-meeting press conference that a March cut is unlikely considering recent murky economic data, and you have a signal that the Fed likely won’t change its new, “no rate cuts anytime soon” stance even at its next meeting in April. Instead, it likely won’t consider any cut until its May meeting as it seeks “greater confidence” that inflation is indisputably approaching its 2% inflation target.
Looking ahead, the Fed will have access to two more months of inflation data by the time its March meeting rolls around, and we anticipate that the data will demonstrate that the 12-month change in core PCE – its favorite inflation gauge – is very near 2.5%. If that’s the case, PCE would have undershot the Fed’s own projections contained in its December Summary of Economic Projections, marking eight straight months of declining inflation, thereby paving the road to a near-term rate cut.
Bottom line: The Fed has now officially made its first step toward cutting interest rates, but there are a few more hurdles to be overcome before it does so. The needed catalyst for rate cuts are consistent data signals that give the Fed “greater confidence” that it is close to meeting its 2% inflation target. The next key data point in this regard is this week’s release (Friday, February 9th) of the annual revisions to the Consumer Price Index (CPI).
January Jobs Report is the Nail in the Coffin for Your March Rate Cut Dreams
Headline nonfarm payrolls increased by 353k in January, much higher than the consensus estimate of 185k. The prior two months’ jobs reports – for November and December 2023 – were revised as usual, netting to a two-month net revision of +126k. Additionally, Average hourly earnings (aka wages) increased 0.6% in January, up from 0.4% in December (not good for the Fed’s inflation fight as consumers have more $$ to spend, putting upward pressure on inflation) and beating out expectations of 0.3% growth. Finally, the unemployment rate held steady at 3.7% for a third consecutive month, below consensus expectations for a minor rise to 3.8%.
The unexpectedly strong job gains in January drastically reduce the odds of a March rate cut by the Fed. The most significant finding is that, according to benchmark revisions, the jobs market ran hotter than realized in the second half of last year after appearing weaker than it had been from late 2022 to early 2023.
Our take: Revisions to the January jobs report were its most significant tell, as they reveal that the jobs market was far hotter in the second half of 2023 than it appeared at the time. That dynamic – combined with falling but still high inflation pressures – makes it tough for the Fed to justify a rate cut anytime soon, as a more-robust-than-thought jobs market also implies upward pressure on wage growth, which then suggests that inflation’s last mile of travel to the Fed’s 2% target will be tougher and take longer. As such, we’re sticking with the call we’ve had for weeks now: The Fed won’t cut until May at soonest.
The fly in the Pinot? The monthly jobs report is always revised after the fact, and all revisions to last year’s jobs reports, outside of December, have been lower. The risk of a significant downward revision to January’s blowout report is high given an abnormally low response to the data-gathering jobs survey, possibly due to poor weather conditions during the month. Could we get a surprising steep downward revision to January’s blowout jobs report? Time will tell.
What to Watch: Second-tier Data to Keep No March Cut Theme in the Headlines
Fed Chair Jerome Powell has demonstrated that he would rather establish policy gradually when things are unclear. Given the murky picture (A Resilient Economy or One on the Verge of Recession. Which is it? ) painted by recent “hard” and “soft” economic data, this is one of the main reasons why we’ve consistently argued against a March 2024 rate cut.
After last week’s bonkers data and event calendar, we’ll all get a break this coming week. Second-tier economic data and events (ISM Services Index – Monday and Trade balance – Tuesday) in the coming week will maintain the market’s current theme – no March rate cut – in the headlines.
For now, markets are logging a 16% chance of a March rate cut (that’s down from 44% this time last week and 69% in mid-January), a 58% chance of a May cut, and a 82% chance of a June rate cut.
Extending or Replacing Your Rate Cap? A Few Things to Keep in Mind
- In general, rate cap costs are down 25-30% from their peak.
- If your cap is in-the -money, where its strike is below SOFR’s current level, expect your lender to require the same in-the-money strike on the extension/replacement rate cap, regardless of how the asset is performing. Hoping for a much higher/cheaper strike? Good luck with that outside of a formal refinancing of the loan.
- Balance sheet lenders are more flexible in rate cap negotiations, CLO funded lenders, much less so.
- We are routinely seeing lenders allow for the term of the rate cap extension to be much shorter than what is written in the loan agreement, e.g., a 90-day extension versus 1-year, saving the borrower money. Why? Given the broad expectation for lower rates, they’re more comfortable with the rate and price risk. However, in all cases, the borrower will have to continue to roll the cap every 90 days if the loan remains outstanding.
- On a construction to mini-perm bridge loan, make sure to work with the lender to allow for the rate cap’s notional amount to sync with the anticipated draw schedule (an “accreting rate cap”). Why pay for “insurance” you don’t need?