Dueling Job Narratives in Focus

What You Missed

The macroeconomic backdrop has been extraordinarily robust ever since the December 2023 Fed meeting, where Chair Powell & Co. took the improbable step of pivoting toward interest rate cuts even while reiterating economic optimism. Since then, Chair Powell has consistently delivered the same message. That, along with dovish remarks from other central banks around the world, helped keep downward pressure on short-term interest rates over the past week. It’s increasingly becoming clear that the inflation genie will not be returned neatly into the bottle, and by extension, that the Fed is willing to tolerate inflation that bobs around 3% in its quest to achieve a “soft” or “no” economic landing. That means the Fed will become increasingly focused on its other mandate: jobs.

Running the Numbers: Rates Flat Amid Shift in Focus to Jobs

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Bond traders are placing bets that inflation will stay high as Fed Chair Powell begins to increasingly stress the need to safeguard the jobs market. Last week, Powell made it apparent that he is no longer solely focused on bringing down inflation. If the unemployment rate were to spike unexpectedly, he indicated that the Fed would have the motivation to move more quickly toward cutting interest rates despite inflation being above the Fed’s 2% target, implying that the Fed may feel it has made enough progress in its inflation fight. For perspective, the annual core inflation rate is now 2.8%, down from 5.6% two years ago.

Rates markets aren’t so sure. Swaps traders reduced their bets – only slightly –  that the Fed would cut rates as soon as June. The implied probability of a June rate decrease is now roughly 60%, down from a 66% probability at the start of last week. However, not much had changed in terms of economic data since Powell’s speech last week. For more on this topic, check out our Q2 Interest Rate Outlook.

For the week:

Where will SOFR be a year from now? 3-month (CME) Term SOFR, a more useful gauge of hedging costs than 1-month Term SOFR, fell one basis point to 5.30%. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘25), an estimate of where markets expect 3-month Term SOFR – and by extension, hedging costs –  to be a year from now, rose six basis points week-over-week, to 4.30%, reflecting the “higher for longer” view permeating rate markets.

How much higher will SOFR rise? 1-month SOFR, via the SOFR forward curve, implies that one-month SOFR has peaked near 5.33%, 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 3.57% in December 2027.

Where is the 10-year Treasury yield headed? The 10-year Treasury yield forward curve implies that the yield will bottom out at 4.06% in January 2025 – it’s sitting at 4.25% right now, and posted a 4.99% 12-month high back in October –  then stage a slow and steady sequential rise. We suspect that a 10-year Treasury at 4% – assuming the Fed is ultimately successful in bringing inflation down to its 2% target – will be Fed Chair Powell’s long-term legacy.

When will rate cap costs decline? Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, fell once again week over week, now sitting firmly at a two-year low. Rate cap costs continue to hover 25-30% below their peaks and will likely continue their downward path as the first Fed rate hike gets closer. Curious what a rate cap costs? Check out our rate cap calculator.

Elsewhere, equities are trading near record-high territory as upward momentum remains strong. The price of a barrel of West Texas Intermediate crude oil rose $1.45 from this time last week to $83.58, as the US dollar and Gold both strengthened.

Mellowing Inflation Pressures Paving the Road for Back Half Rate Cuts

Headline and core personal consumption expenditures (“PCE”) inflation both mellowed to 0.3% in February (vs. an upwardly revised 0.4% and 0.5% prior, respectively). Year-over-year, headline PCE inflation rose to 2.5% (vs. 2.4% prior) and core fell to 2.8% (vs. an upwardly revised 2.9% prior).

The Fed’s preferred “supercore” inflation gauge, which measures core services but not housing rents, dropped precipitously to 0.2% month over month in February (from an upwardly revised 0.7% prior). Year-over-year, the gauge rose to 3.3% (versus 3.5% prior). On a one-, three-, and six-month basis, a method the that the Fed likes to use to analyze inflation’s movements, supercore inflation rose 2.2%, 4.5%, and 3.8%, respectively (vs. upwardly revised prior readings of 8.2%, 4.5%, and 3.5% respectively). All good news to help pry open the door to rate cuts.

Also contained in the PCE data was evidence that growth in consumer incomes slowed. This is important given that roughly 75% of all US economic activity is driven by the consumer. Personal income increased just 0.3% during February (vs. +1.0% prior), below consensus expectations of a 0.4% increase. Disposable personal income increased a more modest 0.2% (vs. +0.4% prior) and fell 0.1% after adjusting for inflation. Further, real personal spending growth rose 0.4% in February (vs. a downwardly revised -0.2% prior), with most of the spending growth in motor vehicles and transportation services, after a chilly January pressured spending.

Our take: Although the upward revisions to the previous month’s data take some of the shine off the report, the Fed will undoubtedly be pleased to see that inflation is cooling. However, the continued rise in incomes and spending doesn’t bode well for inflation’s continued fall long term, even though the rise in personal spending was mostly focused in areas of the economy bolstered only by the wealthiest segments of society. The Fed’s rate cut strategy will solidify as the inflation and spending data continue to show a two-track economy, paving the way for a rate cut in July.

Pop in GDI Reflects Two-Track Economy

Following upward revisions to GDP and a massive first estimate of Gross Domestic Income (GDI), the economy expanded by 4.1% on average in Q4. Strength in the GDI was driven by the recent stock-market rally, even as wage compensation slowed. The data generally demonstrate how the real economy has benefited from looser financial conditions despite the Fed’s 5.25% in rate hikes.

In the third estimate for Q4 2023, real GDP was revised higher to 3.4% (from 3.2% in the second estimate). Due to higher spending on services, consumer spending was revised up to 3.3% from 3.0% previously. While there was a decrease in business inventories, overall business investment increased, particularly in structures (up 10.9% compared to the previous estimate’s 7.5%).

Our take: As the stock market rally that we’re all loving implies, buoyant corporate profits are largely a result of easier overall financial conditions. However, wage growth is shifting lower, a clear indication that consumer spending and economic growth will suffer for those on the lower end of the compensation scale, who don’t generally benefit from owning lofty stocks. On the other end of the spectrum, those on the upper end of the income scale – helped by lofty stock prices –  are boosting economic growth, the result of which will help drive the Fed’s next move.

What the Baltimore Bridge Collapse Means for Inflation, and Fed Rate Cuts

While the Port of Baltimore is a minor player among US ports overall – the Bureau of Transportation Statistics ranks it 17th in terms of total tonnage, and handles ~3% of US imports – it does serve as an important node for automobile and machinery equipment imports.

The most likely scenario is that there won’t be any noticeable effects if the port quickly reopens. A protracted disruption that rattles auto supply chains, raises freight costs, and pushes year-end inflation up by a tenth or two is the high-risk scenario. With the degree and timing of the first Fed rate cut hinging on very small improvements in inflation, such an outcome could push back the first rate cut from July to September.

What to Watch: Dueling Job Market Narratives to Keep Fed on Sidelines for Now

When asked what might lead policymakers to lower interest rates sooner than expected following the FOMC meeting in March, Fed Chair Powell referenced “unexpected” events. Since the Fed has seemingly accepted the fact that the last mile to driving inflation to its 2% target will take longer than expected and seems to be comfortable tolerating inflation pacing above that level – the annual core rate is down to 2.8% from 5.6% two years ago – a speedier deterioration in the jobs market could be the catalyst to rate cuts the Fed is looking for. It wouldn’t be difficult for the jobs market to provide that unfavorable surprise, given that the Fed has projected a 4.0% unemployment rate for year end-2024, which is just slightly higher than the  current 3.9%.

We doubt the employment situation has worsened, and suspect that this Friday’s jobs report for March will show unemployment holding steady at 3.9%. If we’re wrong, and the unemployment rate met or breached the Fed’s 4.0% year-end projection, the Fed will have more reason to cut rates sooner than the July cut we’re expecting.  On the flip side however, the headline nonfarm payroll number is expected to be strong, coming in somewhere near 200k in new jobs for March, which is significantly higher than the 100k in monthly job gains Fed Chair Powell previously considered to be the “neutral” rate of job growth. Such an outcome – 200k+ in new jobs for March –  would be an unequivocal signal that the jobs market is tight.

How does one reconcile these conflicting narratives? One explanation, which is becoming more and more popular, is that the 2022–2023 immigration wave in the US has caused the monthly “neutral” pace of job creation to be more along the lines of ~200k, twice the pace assumed by Fed Chair Powell . Using that logic, even if nonfarm payrolls added fewer than 200k jobs in March, the unemployment rate may still have risen above 3.9%. Time will tell.

Is immigration reflected in nonfarm payrolls data though? It’s debatable. While the data doesn’t specifically identify the legal status of workers, it is likely that both the Household Survey and the Establishment Survey, which contribute to the monthly jobs report, include at least some undocumented immigrants. However, the surveys are not designed to determine how many undocumented workers are counted.

There are likely much less interesting explanations for reconciling the two competing job market narratives. Instead, the birth-death model, seasonal factors, and cyclical sectors of the economy that still face a labor shortage continue to be the main causes of the recent solid jobs prints, a scenario that doesn’t prevent a unemployment rate at or above 4%.

For now, the general trend indicates that the job market is cooling. WARN notices, a notification that employers must provide to give advance warning of significant layoffs or plant closures, have increased recently, and numerous business surveys (ISM Manufacturing, Monday) indicate a slower hiring pace and an increase in layoff announcements. In addition, for two of the previous three months, the quit rate (JOLTS, Tuesday) has decreased.

Outside of the jobs report, markets will be focused on a parade speaking engagements from Fed officials, including a speech by Chair Powell on Wednesday.

See You at NAFOA

Derivative Logic is a sponsor at the upcoming Native American Financial Officers Association (NAFOA) April 29th and 30th in Hollywood, Florida.  Rex Evans will be in Atlanta May 2nd and May 3rd and Jim Griffin in New York.  Please let us know  – us@derivativelogic.com – if you would like to meet with us.

Use of Swaps is on the Rise

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