Don’t Fall for the Soft Inflation Head Fake
What You Missed
Asset markets have rallied for several months whenever investors perceived that the Fed might be getting ready to pause or reverse its tightening cycle. This “bad news is good news” dynamic may be finally breaking down; equities and bond yields both fell last week amid mounting evidence that the Fed may be on the cusp of a pause, indicating that bad news for the economy will probably be bad news for asset markets too.
The indicators of a future of slowing economic growth are piling up. According to the Atlanta Fed GDP Now model, Q1 GDP growth slowed from a 3.5% pace just two weeks ago to a projected 1.5% growth rate. The change was substantiated by a slate of less than inspiring economic data, notably a sharp drop in the Institute for Supply Management’s nonmanufacturing PMI, a fall in the manufacturing PMI to recessionary levels and a larger-than-expected decline in the number of job openings in February. As of now, futures markets are predicting only a 44% chance of a 0.25% Fed rate hike at its upcoming meeting on May 3.
But is the Fed really done hiking as markets imply? We don’t think so. Let’s deconstruct the market sentiment for a moment to gain a clearer sense of the Fed’s likely intentions in the face of what seems to be mounting evidence of a slowing economy.
**Borrrowers: Have you received a notice, like this one from your rate cap bank asking you to contact them to address the LIBOR transition? Contact us before you respond, as making the wrong decision will cost you money.**
First up, is the jobs market really slowing as much as markets think? Probably not. America’s economy created 236k jobs in March, slightly higher than the 230k consensus forecast, but still lower than February’s upwardly revised 326k gain. The net change over the past two months was -17k, as average hourly earnings (aka wages) cooled faster than expected. The jobs data – released last Friday – implied that the tight labor market is being made worse by the persistent lack of workers in some service sectors.
Sure, the Fed is likely relieved to hear that hiring slowed in March compared to the previous two months, but the pace of hiring is still too high to put them at ease. When combined with the unemployment claims and JOLTS data data provided early last week, the Fed is likely convinced that interest rates are close to as high as they need to be, but not quite. As such, they’ll hike the Fed Funds rate by another 25 basis points on May 3rd, to a peak of 5.25%, then hold rates there for the rest of the year.
In peeking at the other two important data sets released last week – the ISM non-manufacturing PMI and its manufacturing counterpart – cooling demand for services and goods shows vulnerability in a crucial economic drivers heading into spring. It will be difficult to avoid a recession this year with recent banking turbulence, increasing uncertainty, spiking oil prices, and a US economy that’s yet to feel the full effects of the Fed’s aggressive rate hikes.
Finally, OPEC+ surprised markets with a 1.6-million-barrel-per-day output cut, blaming the US’ refusal to replenish the Strategic Petroleum Reserve if prices dip below $70 per barrel. After gaining about 7% last week as a direct result of the OPEC+ announcement, West Texas Intermediate rose beyond $81 per barrel over the weekend. Even if OPEC+’s unexpected move has revived bets of higher oil prices, several demand indicators are displaying symptoms of weakness as economic slowdown worries persist. This week’s monthly outlooks from OPEC and the International Energy Agency will give crude traders important market information.
Running the Numbers – Hedging Costs Fall Amid Calming Markets
After another volatile week, yields across the maturity spectrum ended slightly lower than where they started. For the week, the 2 and 5-year Treasury yields rose one basis point respectively, as the 10 and 30-year fell two and three basis points.
3-month (CME) Term SOFR, a more useful gauge of hedging costs over Term SOFR’s 1-month version due to its vast liquidity, continued trading well-off all-time highs near 5.12% for a fourth week, rising to 4.96%. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘24), a rough estimate of where markets expect 3-month Term SOFR to be a year from now, rose four basis points from this time last week, to 4.12%, reflecting the growing consensus that the Fed is nearly done with its hiking cycle.
The SOFR futures market, a widely observed signal for how SOFR will behave in the coming months, implies that 3-month SOFR is already close its peak of 5.27% (it’s 4.96% now), and still expects SOFR to stage a significant decline over the next year – starting as soon as June – as the Fed pauses and eventually eases.
Finally, interest rate volatility, a key driver of the cost of interest rate caps, fell throughout the week, continuing to back off eye-wateringly high levels seen in mid-March. Elsewhere, equities were modestly lower on the week amid signs the US economy is losing steam. The US Dollar strengthened, and gold weakened.
Borrowers Beware: The LIBOR to SOFR Transition Is Not Your Friend
We’re being flooded with calls and emails from borrowers who were recently informed by their lender that their LIBOR-based, floating rate loan would be converting to a new floating rate index, SOFR. Don’t be fooled, there is nothing standard or routine about transitioning the index in your loan or transitioning the index in your rate cap or interest rate swap.
Confused or uncertain about how the transition will impact you? Give us a call, 415 510-2100, to help guide you through it with as little damage to your bottom line as possible. Make no mistake, making the wrong decision will cost you money.
US Dollar Demise? Not so Fast.
Readers of this newsletter may not be aware that a decent portion of Derivative Logic’s business is helping investors hedge exchange rate (aka currency/foreign exchange) risk. Since many in financial markets have been speculating about the emergence of a multi-polar currency world as China, Russia, and others attempt to free themselves from a financial web that leaves them susceptible to US sanctions, it’s worth commenting on.
It appears as though dire warnings of the dollar’s impending demise as the world’s reserve currency have been revived over the past week or two. By this point, it has become a tired trope that periodically reappears before fading away with little to no lasting effect, and new information hasn’t altered the reasoning in any significant way.
Here’s why. First off, a genuine alternative to the dollar will need to permit the use of its currency as a store of value, and that requires a sizable pool of secure (from credit risk, at least) assets. Secondly, anyone selling trillions of dollars (or yuan, or rubles, or whatever) worth of safe assets to a world looking to diversify away from the dollar is going to a) witness their currency rise in value significantly, b) run a capital-account surplus, (aka, watch money leave their country en-masse), and c) as a result of the first two, run a current account deficit (aka, imports exceed exports).
As Europe and Japan were reluctant (or unable) to undergo this change before them, there is little sign that nations like China or Russia are eager to do the same. The demise of the dollar could make for an entertaining tale, but unless someone else is ready to take on the responsibilities that come with what some call America’s undue advantage, that’s all it will be: an entertaining tale. Besides, when the crap hits the fan globally, in what currency do you want your assets denominated? Enough said.
What to Watch This Week – Falling Inflation to Resurrect Rate Cut Bets
Slowing growth and stubbornly high inflation make it difficult for financial markets to determine the next market catalyst, raising doubts about whether upcoming readings on the state of inflation are really as important as the shifting focus toward the economy’s and profits’ slowing growth.
In the coming week, financial markets may find fresh reasons to place bets that the Fed will cut interest rates by the end of the year. Wednesday’s and Thursday’s likely weak reading on the state of inflation – via the headline consumer price index (CPI) and producer price index (PPI) readings for March – along with Friday’s soft read on retail sales, may reignite speculation that the Fed’s war on inflation is over. Elsewhere, earnings season officially gets underway on Friday with results from JPMorgan Chase & Co., Wells Fargo & Co., and Citigroup Inc. If profits are seen declining precipitously, it will add fuel to the “fed is done hiking” argument.
Hold your horses, as there’s a fly in the merlot: OPEC’s recent announcement of cuts in oil production, which will help high inflation stick around for longer, and could reverse some of the Fed’s recent wins on that front.
How the Fed responds will depend on how long the oil shock lasts. The minutes from the March Fed meeting, set for release on Wednesday, are expected to reflect the Fed’s commitment to using monetary policy tools to combat inflation while also committing to use liquidity tools to resolve the recent instability in the banking sector. As fears over banking instability continue to subside, reliance on the Fed’s credit and liquidity facilities has plateaued, giving the Fed more optionality to hike rates if the oil price shock turns out to be long-lasting.
We’re in the midst of a wave of inqueries from borrowers who are seeking ways to benefit from a steadying or decline in interest rates over the coming months. Curious? Reach out to us.
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Source for all: Bloomberg Professional