Bumpy Road to Rate Cuts

What You Missed

The latest reading on inflation – via the widely watched Consumer Price Index (CPI) – came in lower than expected, taking rates markets by surprise. Other economic data indicated that household spending is losing momentum, and that inflation is expected to fall further in the near term, allowing the Fed to take a wait-and-see approach and remain on hold. Traders are seizing on the changing narrative, having fully priced-out another rate hike and now anticipate nearly 90 basis points of Fed rate cuts in 2024. We believe that an economic downturn is probably already upon us, and that the markets’ assessment of the data is unduly optimistic, with Fed rates cuts likely to happen later and in a smaller magnitude than markets expect.

Curious where rates are headed through year’s end? Watch our Q4 Interest Rate Outlook livestream, recorded Thursday, October 5th.  Click here or email us@derivativelogic.com 

Running the Numbers: Rates Lower on Cut Expectations

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Motivated by falling inflation and indications of a slowing economy, investors rushed headlong into US government debt, believing that the Fed is done hiking and will pivot to cutting interest rates by June, delivering a total of four quarter-point cuts by December 2024. This spurred Treasury yields to stage a U-turn lower across the curve, to their lowest levels since September.

For the week:

2-year Treasury yield: down 13 basis points to 4.62%

5-year Treasury yield: down 20 basis points to 4.46%

10-year Treasury yield: down 18 basis points to 4.46%

30-year Treasury yield: down 13 basis points to 4.61%

1-month Term SOFR: flat at 5.33%

Where will SOFR be a year from now? 3-month (CME) Term SOFR, a useful gauge of hedging costs, fell one basis point to 5.37%. The implied yield on the 3-month SOFR futures contract 1-year forward (December ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, fell 15 basis points week-over-week, to 4.40%, reflecting the view that the Fed is done hiking and will have engaged in several rate cuts by this time next year.

How much higher will SOFR rise? 1-month SOFR, via the SOFR forward curve, implies that one-month SOFR has already peaked at 5.34%, and will decline precipitously over the next year as the Fed eventually cuts interest rates several times through 2024.

Will rate cap costs ever decline? Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, continued to fall, now sitting at levels last seen in late September. Any sharp fall in rate volatility, like that seen over the last two weeks, helps to drive rate cap costs lower. However, until there are clear signs that the Fed is firmly 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 rose as improved US inflation data reinforced the notion that the Fed’s tightening cycle has ended. The price of a barrel of West Texas Intermediate crude oil fell $0.70 to $77.56 from $78.26 a week ago, as the US dollar weakened, and Gold strengthened.

Fall in CPI is Enough to Keep Fed on Hold

Overall, October’s CPI – the widely watched monthly gauge of inflation that’s been driving the interest rate narrative for months – fell more than expected, coming in unchanged month over month from September’s 0.4%, but significantly falling year over year to 3.2%, from September’s 3.7%.

Core inflation, which excludes food and energy prices, decreased month over month to 0.2% (from 0.3% previously), and the annual rate of change moderated to 4.0% (from 4.1% previously). Core CPI is now running at 2.8% annually, which is close to the Fed’s 2% target.

What’s driving the fall? Core goods prices fell by 0.1%, marking the fifth consecutive monthly decline, driven mostly by a continued fall in auto prices. The general trend indicates that due to previous Fed rate hikes, both new and used car prices will continue to fall through 2024.

On the other side of the coin, core prices for services dropped to 0.3%, the lowest level since June. That was caused by a decline in lodging expenses and a slowdown in rents. While the primary rent inflation rate stayed at 0.5%, owners’ equivalent rent, the amount of rent that would have to be paid in order to substitute a currently owned house as a rental property, decreased to 0.4% from 0.6%. Lodging decreased 2.5% (previously +3.7%).

Record-low housing affordability is squeezing homebuyers and renters, with no end in sight, and is a big focus of the Fed. This, in combination with homebuilder confidence slumping, likely means higher home prices as builders hold back on projects. It’s a combination that could exaggerate supply shortages and keep housing inflation high, spurring the Fed holder interest rates higher for longer than markets expect.

Our take: October saw a resurgence of the disinflationary trend, with core CPI gains slowing to a pace more in line with the Fed’s objectives. Looking ahead, the headline CPI for November, set for release in mid-December, is predicted to be similarly weak given the decline in oil prices this month along with an expected decline in rents and lodging. As such, the Fed will be justified in sitting on its hands – holding steady on rates – at its next policy meeting on December 13th.

More Signals that Consumers are Tightening their Belts

After September’s unexpected strength, consumer spending slowed in October. It’s a clear signal that student-loan repayments, slower wage growth, and rising consumer interest rates are weighing more heavily on household budgets.

Headline retail sales for October fell 0.1%, vs. an upwardly revised +0.9% in the month prior and consensus expectations of a 0.3% decline. Retail sales in the control group, which are used to calculate the overall growth of the economy (GDP) and don’t include building materials, vehicles, gas, or food services, increased by 0.2% month over month (versus 0.7% in September).

Up until now, consumer spending – which alone drives roughly 70% of all US economic activity –  has been a major force behind economic growth. The slowdown confirms our belief that the economy is likely in a downturn or will be very soon, lending yet another justification for the Fed to end its rate hiking campaign and eventually pivot to rate cuts mid to late next year.

What to Watch: Minutes to Support Fed’s On-hold Stance

Now that pretty much everyone and their dog has concluded that the Fed is done hiking, it’s fun to see how the euphoria manifests in the minds of those in industry. Many interpret recent economic data  – which signals the economy is slowing amid a stable jobs market – as showing an “immaculate disinflation,” where inflation declines toward the Fed’s 2% target without sparking a sharp rise in unemployment.

We’re not so optimistic. Consumer demand is indeed cooling, which is reducing inflation pressures. Because of a slowdown in global demand, oil prices are falling. If we’re not in a recession already, the US economy is likely perilously close to entering one, as are many other economies in the world.

The way the Fed evaluates the incoming data in the coming months will have a significant impact on the direction of the US economy. Fed decision-makers may stop an impending downturn in its tracks if they choose to act promptly – via aggressive rate cuts – upon detecting the first signs of a cooling economy. On the other hand, if history is any guide, the first interest rate cut will probably occur long after a downturn has started, especially if the Fed isn’t totally convinced that interest rates are high enough to truly smother the inflation dragon.

Tuesday’s release of minutes from the Fed’s November 1st meeting will give the clearest indication of where the Fed’s head is, and while it’s likely show that they are leaning toward rate cuts, they’ll likely happen later and in a smaller magnitude than markets expect.

Looking to next year, barring some unexpected surge higher in inflation, the job market will be the likely driver of what the Fed chooses to do. Judging by how aggressive markets expect the Fed to cut interest rates next year – four cuts of nearly 100 basis points in total – it implies a world of hurt in the job market and is in direct conflict to what the Fed expects as implied by its forecast back in September. Bottom line? Markets and the Fed’s expectations of the degree and timing of rate cuts are far apart, ensuring that it will be a bumpy road ahead as this yawning gap in expectations is reconciled.

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.

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