Careful What You Wish For
What You Missed
Last week’s Fed meeting revealed that it’s finally officially considering rate cuts, igniting an explosive financial market rally, driving short-term Treasury yields down to levels last seen in June. The Fed’s much-anticipated “dovish-pivot” came on the heels of data that suggested the Fed’s favorite inflation gauge, the core PCE deflator, likely hit the Fed’s 2% target in November. By week’s end, financial markets implied that they expect the first rate cut as soon as March, and nearly 160 basis points of rate cuts over the course of 2024. We agree that rate cuts are coming but expect the first to occur a little later – in May – and that most of next year’s cuts will come in the second half of the year as the Fed takes its time amid a resilient US economy.
Are you wondering where rates are headed in early 2024? Watch our lively and quick Q1 2024 Interest Rate Outlook livestream, recorded on Wednesday, December 13th. Click here to watch.
And, keep an eye out for our 2024 Annual Interest Rate Outlook, dropping during the second week of January. Get a smart start to your year with our comprehensive overview of the important influences behind the interest rates impacting you and your business.
Running the Numbers: Rates Down Sharply on Fed Pivot Hopes
Looking for live market rates and historical interest rate data? Check out our Interest Rate Dashboard.
Traders positioned themselves to benefit from the Fed’s pivot by loading up on shorter maturity debt that still provides a 4%-plus yield, e. g. 2-year Treasuries, for fear that interest rates on a chunk of the nearly $6 trillion parked in money-market funds could soon plunge. In addition, investors’ growing lack of interest in longer-term debt – they expect to be compensated for the added risk in owning a longer-term investment – will eventually cause the yield curve will steepen back to its more typical upward slope, and there is a strong conviction among the markets that the US economy may avoid the recession that was previously seen as all but inevitable.
For the week:
2-year Treasury yield: down 29 basis points to 4.42%
5-year Treasury yield: down 34 basis points to 3.91%
10-year Treasury yield: down 30 basis points to 3.93%
30-year Treasury yield: down 29 basis points to 4.04%
1-month Term SOFR: flat at 5.36% (SOFR won’t move markedly lower until we’re closer to a Fed cut)
Where will SOFR be a year from now? 3-month (CME) Term SOFR, a useful gauge of hedging costs, held steady at 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 thirty-five basis points week-over-week, to 3.87%, hammering home the market view that the Fed is done hiking and will have engaged in a handful 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 near 5.35%, 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 3.13%, but not until July 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 week over week, despite the large move in Treasury yields. While rate volatility moved lower, it’s still high historically. Yes, rate cap costs would seem to logically decline as lower rates show up, but remember those price declines will be neutralized somewhat by bouts of higher rate volatility as we travel down the road toward the first Fed rate cut. Curious what a rate cap costs? Check out our rate cap calculator.
Elsewhere, equities were sharply higher on the week, with several indices, including the Dow Jones Industrial Average, closing in record territory in recent days. The price of a barrel of West Texas Intermediate crude oil rose about $1.93 from last week to $73.24, as the US dollar weakened, and Gold strengthened, trading close to a record high.
Fed Signals No More Hikes, that Cuts Around the Corner While Embracing the Soft-Landing Scenario
In its scheduled monetary policy meeting last Wednesday, the Fed’s rate-setting committee voted unanimously to hold rates steady at 5.50% (upper bound) for a third consecutive meeting. Although the Fed remaining on hold was widely expected, it was unclear if the Fed would acknowledge the end of its hiking cycle. The updated dot plot and tweaks to the official meeting statement gave us the answer, with both sending an undeniable signal that the Fed is done. The cherry on top was Fed Chair Powell’s post-meeting comments, which did little to dissuade markets from assuming the first rate cut is around the corner.
Looking ahead to the Fed’s next policy meeting on January 31st, the Fed will either stay on hold or cut, but the data of late imply that the Fed’s first cut won’t happen until it’s March 22nd or May 3rd meeting.
Let’s dig into some details briefly so that you can be the most interesting (or boring) person at the company Christmas party:
- The Fed’s revised dot plot saw downward revisions to the future path of the Fed Funds rate, with year-end 2024 projected at 4.6% (versus 5.1% in the prior dot plot released back in September), and 3.6% for year-end 2025. With the Fed Funds rate at 5.50% currently, that implies around 0.75% of cuts next year and 1.00% of cuts in 2025. Remember that in hindsight, the dot plot always turns out to be a horrible predictor of what the Fed does, but the changes in the dot plot are encouraging nonetheless.
- The median estimate for core PCE inflation – a key metric for the Fed – at year’s end 2023 was revised down to 3.2% (from 3.7% previously) in the most recent Summary of Economic Projections (SEP). The forecast was reduced to 2.4% in 2024 (from 2.6% previously) and 2.2% in 2025 (from 2.3% previously). This change tells the world that the Fed believes it’s inflation fight is nearly over, serving as an implied green-light for a near term cut in the Fed Funds rate.
- The strongest indication that the Fed’s hiking cycle has come to a close came from a minor but significant change to the meeting statement, which we read so you don’t have to. The previous statement’s crucial phrase, “in determining the extent of additional policy firming,” was altered by substituting the word “any” for “additional.” This is what one has to do to try and read the Fed’s mind but bolsters our belief that most Fed officials concur that rates are already sufficiently high and that more rate hikes aren’t needed.
- Finally, the most important takeaway from Chair Powell’s post-meeting remarks was that he indicated that the first rate cut will occur well before core inflation hits the Fed’s 2% target, as waiting to cut until inflation hits the target would be “too late” and put the economy at risk. With core-inflation falling ever so slowly, it tells us that the first rate cut would occur in early Q2 2024, at which point the six-month annualized core PCE inflation rate – if it maintains its declining pace – would have declined to somewhere near 2.2 to 2.3%.
Bottom line? The Fed has caved to market expectations of near-term rate cuts, now firmly believing that an economic soft-landing is a sure thing. The question now is how the mile-wide gap between what rate cuts the market expects next year (~160 basis points) versus what the Fed is implying (75 basis points) gets reconciled. Financial markets are betting that real economic outcomes – economic growth, inflation, and employment – will be worse for us all than what the Fed expects. After all, the Fed doesn’t ever cut interest rates aggressively if the economy is doing well. Perhaps we should be careful what we’re asking for.
Latest Inflation Gauges Support Fed’s Pivot to Cuts
The Fed’s preferred inflation gauge, the core PCE deflator, appears to have been very subdued in November, as evidenced by Consumer Price Index (CPI) data released last week.
While the year-over-year change fell to 3.1% (from 3.2% prior), as expected, the headline CPI for November increased by 0.1% (from 0% prior), exceeding expectations. Core CPI, which the Fed really cares about, increased slightly month over month to 0.28% (from 0.2% previously), exceeding expectations of 0.27%. Annualized, core CPI is currently running at 3.5%, with the year-over-year pace holding steady at 4.0%.
CPI increased 3.5%, 3.4%, and 2.9% on a one, three, and six-month annualized basis – important metrics that the Fed uses to gauge inflation’s momentum. That’s the first time the six-month measure has fallen below the psychologically significant 3% threshold since the Spring of 2021. In contrast, October readings were 2.8%, 3.4%, and 3.2%, respectively.
Most of inflation’s slight increase last month was driven by services. Core services inflation increased to 0.5% (from 0.3% previously), primarily due to increased expenses for housing, transportation, and healthcare. While primary-rent inflation remained mostly steady at 0.5%, owner-equivalent rents increased to 0.5% from 0.4% previously. Lodging dropped by 0.9% (previously -2.5%). In comparison to last year, shelter costs probably peaked last March at 8.2% and will progressively drop to less than 6% by year’s end while remaining one of the stickiest sources of inflation in the economy.
Yes, we hear from many of our clients that the Fed is using the wrong measures (e.g. the lagged shelter category) of rents in its rate-setting calculations, resulting in them keeping interest rates too high for too long. In fairness though, no one was making that claim as rents were rising. The same quirkiness existed in the Fed’s gauge of rents back then – they haven’t changed their methods – allowing some to argue that interest rates were too low for too long in the midst of rising inflation. Can’t have it both ways, folks.
Bottom line? November’s CPI data wasn’t all that encouraging, with overall inflation ticking higher. Nevertheless, there are a few reasons for hope: For the first time since spring 2021, as mentioned above, the six-month annualized measure has dropped below 3%, indicating that inflation’s longer-term trend is pointing in the right direction. Moreover, China’s current deflation situation is helping; by exporting now lower priced goods to the world, it’s helping to drag prices of goods lower overall, assisting the Fed in its mission, and adding momentum to the likelihood of rate cuts next year.
What to Watch: More Reasons to Cut Rates
As we said over the last couple of weeks, the Fed was likely shaken up by November’s Beige Book, which showed the mood on main street was the most pessimistic since 2020. They’ll likely get more confirmation of such over the course of this week, via news of declines in business activity and weakening labor-market conditions (consumer confidence, Wednesday and Philadelphia Fed business outlook survey, Thursday). Second, another set of inflation gauges (Personal Consumption Expenditures, Friday) adding to the narrative of falling inflation toward the Fed’s 2% target.
As revealed last week, the Fed seems to think that an economic soft landing is guaranteed. We’re not so sure about that. Chair Powell asserted that there is room for rate cuts because inflation is gradually declining and there hasn’t been much of an increase in unemployment. We suspect that the lagged effects of the Fed’s blazing rate hikes may be about to show their impact on the jobs market, and that the dynamic for a brief and shallow recession is beginning to show itself.
In the meantime, we’ll also get more signals of the durability of the falling inflation dynamic this week. If consumer confidence (University of Michigan sentiment survey, Friday), income and spending strength (Friday), and house prices (existing home sales, Wednesday and housing starts, Tuesday) rebound from the recent drop in mortgage rates, inflation’s falling trend may reverse.
Question Your Knee Jerk Reaction to Refinance into Fixed-Rate Debt
We’ve mentioned on numerous occasions over the course of this year that a borrower’s flexibility is paramount in this world of high interest rates. Now that rate cuts seem to be around the corner, borrowers that rushed to refinance into a fixed rate for 3 or 5 years may not have have made the best decision in hindsight.
In our experience, making any decision based on fear usually has negative consequences dwon the road. We can’t express enough how important it is to reach out to an advisory firm with years of capital markets experience for objective advice. While some borrowers may feel that their decision to fix may have been the right one, it’s always important to examine the context in which the decision was made, as interest rates rarely stay high for very long. Need some perspective on how long rates have stayed high historically? Check out our Interest Rate Dashboard.