Confused Markets Look to Data for Direction

What You Missed

The events of the past week served to continue to lead markets steadily toward a “rates are going to stay high and be there for longer” mindset. Of note were continued signs of an economic soft-landing and Fed Chair Jerome Powell’s Jackson Hole speech; both of which led markets to raise their expected peak of the Fed Funds rate, implying that they believe the Fed will hike rates one more time before it’s finished.

We’re not so sure about that, as the economy’s underlying fundamentals give reason for pause. Sure, like everyone else , we expect the Fed to keep rates higher for longer to battle inflation, but we doubt another rate hike will be needed.

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Running the Numbers: Confused Markets Search for Direction

For the week:

2-year Treasury yield: up 5 basis points to 5.05%

5-year Treasury yield: down 6 basis points to 4.41%

10-year Treasury yield: down 15 basis points to 4.19%

30-year Treasury yield: down 20 basis points to 4.25%

1-month Term SOFR: up 1 basis point to 5.33%

3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, rose four basis points to 5.42%. 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 twelve basis points point week over week, to 4.72%, reflecting the shaky conviction by some in markets that the Fed may not be done hiking rates just yet.

The SOFR futures market, and the forward curve it projects to the world, implies that 3-month SOFR is already near its peak, and forecasts that it will peak in the fall, at 5.48% (eight basis points higher from this time last week), then decline consistently over the next year as the Fed eventually cuts interest rates in Q2 2024.

Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, fell to a two-week low. Elsewhere, equities were little changed on the week as higher-for-longer interest rate psychology largely offset upbeat AI-related earnings reports. A barrel of West Texas Intermediate crude oil fell slightly to $79.81. The US Dollar and Gold both strengthened.

Fed’s Jackson Hole Speech Spooks Market Fears of Even Higher Rates

In Jackson Hole last week, markets seized on three aspects of Fed Chair Powell’s speech: 1) that the Fed may not be done hiking rates just yet, 2) his veiled allusions to the greatest central bank Chief of all time, Paul Volker, and 3) the reiteration of the Fed’s commitment to its 2% inflation target.  In short, Powell positioned the Fed with tremendous optionality – not really committing to one direction or another – keeping markets guessing in the process.

Powell has now split markets into two camps: The first is made up of those who believe that 5.00%+ in Fed rate hikes over the past year and the roughly 0.5-point increase in 10-year yields of late will cause a recession and make rate cuts unavoidable in 2024. The second camp is made up of those who feel that the economy is resilient enough to withstand higher rates, with the economy escaping a recession, ending up in a soft-landing scenario where the job market remains strong amid steadily deflating inflation pressures.

Taken together, it’s a scenario that serves to remind markets that economic data (surprise!) will be crucial for determining the Fed’s trajectory. As of now, swaps traders are factoring in a nearly two-thirds possibility that the Fed will hike rate by a quarter-point in November after an anticipated pause next month.

Our take: Reading between the lines, we saw hints that the Fed Chair is optimistic about its inflation fight, that interest rates are already restrictive enough to tame inflation, and that the inflation dragon can be slayed without wrecking the jobs market. To us, Powell seemed to be less convinced that another rate hike would be necessary and has instead adopted more of a wait-and-see approach to further rate hikes. Powell did not specifically rule out rate cuts either. In the end, he gave the impression that the Fed could afford to go forward “carefully”.  That tells us that they’ll be a pause in September, and if the Fed hikes again – which is doubtful – it won’t happen until November at soonest.

The Jobs Market Isn’t as Rosy as you Thought

Over the last year, the government’s jobs reports – the single most impactful economic data on interest rates – routinely surprised economists and markets with higher-than-anticipated job gains. The data were also a major factor in the Fed choosing to hike interest rates as policymakers struggled to keep inflation under control. It turns out that those rosy job reports weren’t as rosy after all.

The jobs report is a compilation of data gathered from a survey taken a few weeks prior and is published to the world on the first Friday of each month. That is not a particularly long turnaround time, and the survey response rates are also not always particularly robust. As a result, even while the monthly employment statistics provide a timely assessment of the state of the jobs market, they are not comprehensive.

Here’s how it works: Based on replies from a sample of employers, the Bureau of Labor Statistics (BLS) publishes an estimate of payrolls for a variety of industries each month. The two previous months of job data are routinely updated with each new monthly jobs report as more firms submit their payroll information. Every year, the BLS compares the number of jobs stated in the March report to the Quarterly Census of Employment and Wages (QCEW), a more precise but slower-moving data source. These QCEW data, which cover almost all US jobs, are based on state unemployment insurance tax records. Once the March payroll data has been adjusted to that count, the change is distributed proportionally across all jobs reports from the previous year.

What does it mean? It means that previous jobs reports were probably inflated by ~300k, according to the preliminary re-benchmarking of projections (for March 2023) of payrolls. That’s about 25k fewer jobs per month over the March 22 to 23 period than were initially reported. Bottom line? The announcement adds to the growing body of data showing a downturn in the jobs market and takes some of the fire out of the argument that the Fed will hike again before year’s end.

Widely Watched Economic Growth Measure Is Flashing Green

The Atlanta Fed’s 3Q23 GDPNow model predicts a whopping 5.8% increase in economic growth for Q3, with strong consumption and increased inventory growth as the main drivers. While the former was bolstered by one-offs like Taylor Swift and Beyonce concerts, the latter is not encouraging when businesses don’t want to hold extra inventory.

Our take: The billion-dollar question now? Will this strong-growth dynamic last. We’re skeptical. A sizable portion of the blowout growth data stems from transitory events, such as the “Barbenheimer” summer blockbusters and Taylor Swift and Beyonce’s concert tours, as well as indicators that may not necessarily reflect underlying strength, like a buildup of business inventories amid declining demand. These factors give the illusion that spending is strong when, in fact, it may be running out of steam. To us, it’s more evidence that the Fed may not need to hike again this year, and, at the least, a September rate pause is likely.

What to Watch: Upcoming Data is Pivotal for Rate Direction

One of the more interesting things Chair Powell said at Jackson Hole was that the moderation of inflation pressures was linked more closely to a decline in wage growth than they’ve been in decades. This assumption will be supported by JOLTS data (Tuesday), a gauge of job turnover, and the August job’s report (Friday), which contains average hourly earnings (wages). It’s likely that the crosscurrents of data will show that wage growth has slowed down swiftly with only a modest softening in the jobs market.

While Chair Powell’s assumption is neat, it’s probably not as neat as it seems due to measurement error. The seemingly positive dynamic between inflation pressures (lower, but barely) and wage growth (slower) isn’t as clear cut as it seems. Why? The jobs report revisions described earlier. The BLS has decreased March 2022–March 2023 private payrolls by more than 300k over the last week. Jobs data in the monthly job reports this year have likewise been continuously revised lower each month. As such, in this Friday jobs report, we’ll be keeping an eye out for a downward revision in the payroll print for July. If it shows up, it will embolden our belief that the economy – specifically the always important US consumer that powers it – may not be as willing to keep the spending train humming.

However, the belief in an economic soft landing has been gaining traction. Construction spending (Friday) has increased likely because of Bidenomics, and the recent manufacturing slowdown (ISM Manufacturing, also Friday) appears to have peaked. The personal income and spending report for July, (Thursday) is expected to indicate a strong increase in the monthly rate of spending, adding fuel to the soft-landing narrative. Could one-offs like “Barbenheimer” and the Taylor Swift and Beyonce concert tours account for most of the increase? We think so.

Rising delinquencies in consumer credit suggest that consumer finances are in bad shape. Consumers who overspent this summer will likely cut back in Q4, contradicting the idea that GDP growth is speeding up. Will it result in a recession? Time will tell.

Strategy Corner: Interest Rate Swaps

We’ve been having an increasing number of conversations with clients who are contemplating borrowing at a floating rate from a bank and fixing that floating rate via an interest rate swap. These conversations are emanating from a myriad of industry verticals: public corporations, Native American Tribes, municipalities, non-profits, and the higher end of commercial real estate.

The prevailing theme? The borrower’s self-acknowledged lack of understanding of interest rate swaps and the need for a trusted, third-party advisor to assist them in navigating the uncertainty.

Here’s a handful of common borrower assumptions we hear all the time that are dead wrong and will ultimately cost the borrower money if not corrected:

  • “My bank is giving me a competitive rate.”
  • “I don’t understand swaps. My bank is educating me and looking out for my interests.”
  • “The bank is betting against me.”
  • “Swaps are the same as gambling.”
  • “Derivatives are risky.”

While we won’t bore you here with rebutting each of the above, you can find detailed explanations here:

I Got a Call – Swap Gambling – Derivative Logic

Interest Rate Swaps: 10 Myths and Misconceptions – Derivative Logic

Rate Cap, Swap and Collar: A Cheat Sheet to Managing Rate Risk – Derivative Logic

Still have questions? Contemplating a swap? Contact Us – Derivative Logic

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