Downturn Has Already Begun
What You Missed
The minutes from the Fed’s November 1st policy meeting showed that the driving force behind its decision to hold interest rates steady were downside risks to the economy stemming from high longer-term interest rates. That, coupled with less-than-inspiring economic data of late means that the Fed will hold rates steady yet again at its next policy meeting on December 13th. Such an outcome sets the Fed up for some difficult policy choices next year due to the combination of slowing growth and still-elevated inflation risks. In the meantime, market analysts are falling all over themselves trying to predict when the first rate cut will come and why, with the consensus expecting a 0.25% cut as early as March. We suspect the Fed’s bar for rate cuts is high, and that its wait-and-see approach will result in interest rates staying higher for longer than most 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 firstname.lastname@example.org
Running the Numbers: Rates Hovering Amid Mixed Signals
Looking for live market rates and historical rate data? Check out our Interest Rate Dashboard.
Signs of slowing inflation and measured jobs growth relegated US Treasury yields to hover (mostly) in the mid to high 4% range over the last two weeks, after peaking in mid-October near highs last seen in 2007. There have been some reversals along the way – including a mild climb in yields at the end of the holiday-shortened week last week. The overarching tone now is that yields will continue their overall retreat with longer-term rates falling more gradually given the barrage of debt issuance needed to fund the ballooning US deficit as the Fed shifts to rate cuts sometime in the first half of 2024. The fall in yields won’t be a straight line – they’ll be many bumps higher along the way – as the Fed isn’t likely to signal a pivot to rate cuts anytime soon as the economy only slowly weakens further over coming months.
For the week:
2-year Treasury yield: up 4 basis points to 4.94%
5-year Treasury yield: up 3 basis points to 4.47%
10-year Treasury yield: up 3 basis points to 4.45%
30-year Treasury yield: up 2 basis points to 4.59%
1-month Term SOFR: up 2 basis points to 5.35%
Where will SOFR be a year from now? 3-month (CME) Term SOFR, a useful gauge of hedging costs, rose two basis points to 5.39%. 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, rose 5 basis points week-over-week, to 4.47%, 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 near 5.39%, 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 on the week as economic data reinforced the notion that the Fed’s tightening cycle has ended. The price of a barrel of West Texas Intermediate crude oil fell $2.57 to $75.24, as the US dollar weakened, and Gold strengthened.
Fed in Wait-And-See Mode Through H1 2024
The Fed’s decision to maintain the federal funds-rate target range between 5.25% and 5.50% was largely influenced by what it called “tighter financial conditions” in the weeks preceding its November 1st meeting. “Uncertainty” about the economic outlook and the cumulative impact of its 5.25% in rate hikes since March 2022 are keeping the Fed on the sidelines.
Long-term interest rates have dropped since the meeting – the 10-year and 30-year Treasury yields are down 0.25% and 0.30% respectively – the jobs market has weakened, and inflation pressures have surprised to the downside. All told, it’s a recipe that will keep the Fed on hold through the rest of the year and into 2024 as it counts on higher long-term rates substituting for another rate hike.
Looking deeper into 2024, the Fed needs more proof that inflation has the potential to fall to its 2% target (it’s 3.2% now) and that the economy will continue to slow amid a stable jobs market before seriously considering cutting rates. When they do finally cut, it will likely be long after a recession has begun, and any series of rate cuts after the first will be a slow and methodical process, far slower than the rapid series of rate hikes seen from March 2022. Bottom line? The Fed won’t cut rates until mid-2024 at the soonest.
Consumer’s Inflation PTSD Persists
Consumers – whose spending accounts for roughly 70% of all US economic activity – still worry that inflation is here to stay and that its recent softening may reverse in the near term. While we all know how important the current state of inflation is to the Fed – and therefore interest rates – what the Fed cares more about is what consumers and businesses expect of inflation in the future, as these expectations can affect spending and investments decisions, and by extension, actual inflation outcomes. As an example, if people expect higher prices in the future, they may demand higher wages, or businesses may raise prices, which can become a self-fulfilling prophecy in driving inflation higher.
According to the final University of Michigan consumer sentiment survey for November, released last week, inflation expectations continued their rise (to 4.5%, up from 4.2% in October), reaching levels last seen in April. It’s yet another sign that the Fed’s inflation fight isn’t over, that rates will stay higher for longer and that, like we said last week, the road to rate cuts will be bumpy and longer than most expect.
Lack of Capex Growth is Keeping Fed on Hold
New orders for durable goods – expensive, long-lasting items like machinery that companies don’t buy often – fell a whopping 5.4% month over month, surprising markets. Compounding the negativity, durable goods data for September was revised down to 4.0% from the previous 4.6%. Outlays for business equipment have now retreated in three of the last four quarters, feeding into sluggish manufacturing activity and implying that factory production will continue to struggle into 2024.
The durable goods dump in October, coupled with September’s sizable downward revision, doesn’t bode well for Q4 GDP. By extension, it gives the Fed confidence that keeping rates where they are was the right call and likely will continue to be into next year.
What to Watch: Fed Beige Book Takes Renewed Importance
Financial markets are reflecting the wide-spread belief that an economic soft-landing is a near certainty. Long-term rates have retreated from their highs as equity markets have rebounded nicely from their October lows. What could possibly go wrong?
The tell-tale signals of a looming economic downturn, notably persistent unemployment, declining real personal incomes, sluggish credit demand, a prolonged manufacturing slump, companies cutting inventory to boost sales, and eroding consumer confidence are all flashing red. Additionally, at times of economic transition, the quality of economic data typically deteriorates. There are signs of such in the monthly jobs report, job openings, and housing starts, which have all been consistently revised lower month over month throughout this year. Simultaneously, history has shown that the data which indicates soft landings have misled policymakers leading into previous recessions, and also why the Fed and Wall Street tend to recognize downturns months after they actually begin.
So, if the economic data and signals from the financial markets can’t be trusted, what’s a central bank to do? Rely on anecdotes. Wednesday’s release of the Fed’s Beige Book – a leading economic indicator whose value increases in times of economic change – will provide anecdotal but crucial hints regarding job market conditions and demand. Even when data still indicated pockets of strength in the economy, anecdotes were among the first signs that a downturn was underway, according to previous Fed meeting transcripts. It probably won’t be any different this time around.
Elsewhere, a recession could already be with us even though auto sales (Friday) will likely show strength, manufacturing signals recovery (Institute of Supply Management Survey, also Friday), household spending remains strong (Thursday), and jobless claims (Thursday) remain low. Markets will also get the next key gauge of inflation pressures via Thursday’s release of personal-consumption expenditures data for October. The data – one of the Fed’s preferred inflation measures – is forecast to show cooling inflation pressures.
We hope our call for a downturn is wrong, and we’ll have to wait to find out, as it will take some time for the data to corroborate our view. In the meantime, what are you doing to best position yourself for a world of lower interest rates by mid to late next year?
Smart borrowers are preparing for lower rates now. For some ideas on how they’re doing it, check out our monthly report: Why Hedge Rates Before they Fall?.
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.