Economic Fog Delays Rate Cut Dreams
What You Missed
The data releases and 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” amid an increasingly mixed economic picture. For every data print that supported hopes for an economic soft landing, another suggested that clouds are gathering on the horizon. Despite the seeming explosion in economic growth in Q2, corporate profits lagged; labor demand and wage growth are declining; and recurrent downward revisions to the always important monthly job reports cause us to discount August’s unexpected boost in hiring. Given the economic fog, we anticipate the Fed to hold rates steady at its meeting on September 20th. Rate cuts? Forget about those until Q2 2024 at soonest.
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Running the Numbers: Jittery Markets Search for Direction
For the week:
2-year Treasury yield: down 19 basis points to 4.91%
5-year Treasury yield: down 5 basis points to 4.35%
10-year Treasury yield: up 3 basis points to 4.23%
30-year Treasury yield: up 5 basis points to 4.34%
1-month Term SOFR: down 1 basis point to 5.32%
Where will SOFR be a year from now? 3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, fell three basis points to 5.39%. 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, fell eleven basis points point week over week, to 4.61%, reflecting the shaky outlook of whether the Fed is done hiking.
How much higher will SOFR rise? 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 5.41%, then decline consistently over the next year as the Fed eventually cuts interest rates in Q2 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 its decline, now sitting at levels last seen in February 2023. Any decline in rate volatility helps to drive rate cap costs lower. However, rate volatility is still high historically, and until there are clear signs that the Fed is on a rate cutting tilt, rate cap costs won’t decline precipitously.
Elsewhere, equities were firmer on the week as Treasury yields eased substantially on hopes that the Fed’s tightening cycle may have come to an end without the US economy falling into recession. The price of a barrel of West Texas Intermediate crude oil surged to $85 from $79.60 a week ago with the expectation that Russia will announce production cuts at an OPEC+ meeting this week. The US Dollar and Gold both strengthened.
Blowout Jobs Numbers are Not What they Seem
The single most impactful piece of economic data on interest rates – the monthly jobs report – implied, at least on the surface, that the Fed would be justified in hiking rates one more time. However, peeling back the layers, things are not as rosy as they seem.
US payrolls climbed by 187k in August, above the consensus estimate of 170k, fueling an initial surge of euphoria in an economic soft landing. The fly in the summer rose? A downward revision of the June and July prints by a combined 110k jobs, along with a slowing of wage growth to 0.2% month on month, down from 0.4% in July. That’s the slowest rate of hourly pay growth since February 2022. The unemployment rate rose to 3.8% from 3.5% due to the labor force increasing (736k) by more than the number of employed (222k), leading to an increase in the number of unemployed (514k).
Our take: There are underlying weaknesses in the jobs picture that contradict the positive look and feel implied by the report’s headline. These weaknesses suggest that the Fed should hit the pause button in its rate-hike cycle. Of note are the significant slowing of wage growth, an increase in labor force participation, but mostly for older workers and prime working-age women, and previous report for June and July were revised lower.
Although the unemployment rate is still low historically, it has steadily risen all year, and each month’s uptick serves as a stark reminder that the risks associated with the Fed’s seemingly conflicting dual mandate – price stability/low inflation and full employment – are becoming more balanced. As such, expect the Fed to sit on its hands in September and November.
GDP vs GDI – What’s the Difference? Should you Care?
Are you a commercial real estate mortgage banker? A CFO of a public company? A treasurer of a municipality or non-profit? You may believe that your role is uniquely specific to the industry you serve; however, the truth is that, ultimately, if you’re involved in debt, you’re in the interest rate business.
One of the primary drivers of interest rates in any economy over the long term is economic growth, or the lack thereof. The most popular gauge of economic growth for America’s economy is Gross Domestic Product (GDP- the total monetary value of all the finished goods and services produced within a nation’s borders over a certain time period. Recent GDP data implies that the US economy has been growing above trend over the past year, and by extension, that the Fed isn’t done hiking interest rates just yet. However, an alternative but similar growth measure, Gross Domestic Income (GDI), tells a different story.
GDI, a less well-known metric than GDP, also measures economic growth, but does so through the lens of income, specifically the total income that all sectors of an economy generate, including wages, profits, and taxes. While we won’t bore you with specifics, just know that GDP and GDI – two different ways of measuring aggregate economic output – should be equal, but over the last three quarters, have been diverging. While GDI witnessed an expansion of just 0.5% in Q2, GDP saw a jump of 2.1% (revised down from 2.4%) over the same period.
Bottom line? There is significant debate over which growth metric, GDI vs GDP, is more reliable, but the Fed’s favored measurement – averaging the two – indicates that the US economy is growing slowly and below trend. Looking ahead, there are temporary factors that will diverge GDI from GDP even further, but it’s likely the Fed will look through the haze and concentrate on weakening corporate profits and sluggish growth in consumer’s incomes, which are ingredients for a recession.
What to Watch: More Signs of Economic Weakness Lurking below the Headlines
Recent financial headlines have supported the popular soft-landing narrative: jobs increased by 187k in August, and consumer spending increased by 0.8% in July despite a 0.2% rise in core producer (wholesale) prices. While inspiring on the surface, we suspect that the headlines are merely a silver lining to an approaching economic storm.
As stated above, peeling back the layers on recent economic data releases suggests that consumption and growth are set to slow now that the summer spending boom – on concerts, travel, and movies – has passed. Previously reported jobs data has been revised down every month this year. Job openings are declining, and wages are growing at their slowest pace since February 2022. With consumer’s personal income falling in July, it’s likely that we’ll see some belt-tightening into the fall and winter.
We expect that the Fed’s latest Beige Book (Wednesday), a smattering of surveys and interviews with businesses, community organizations and economists, will reaffirm that temporary factors have been supporting spending growth and job gains. With the same short-term variables — the demand for entertainment and live events — supporting it, the ISM Services Purchasing Managers Index (PMI – Wednesday) most likely remained stable in August, supported by the temporary entertainment and live events pervasive this summer.
In the fall and winter, consumers should become less eager to spend on live events and discretionary services, which will pave the way for slower consumption and growth. We expect the Fed will follow suit and maintain rates at their September 20th meeting and going forward as they determine the severity of the storm that’ s developing on the horizon.
Rate cuts? Don’t plan on them anytime soon. There are basically two economic scenarios facing us right now: 1) An economic soft-landing, where the US economy continues repectable growth, the job market holds up while inflation pressures cool, or 2) A shallow economic recession late this year or early next. In either scenario, the economy holds up well, and won’t need drastic cuts in interest rates – only minor ones – to continue on that trajectory.
Strategy Corner: Extending an Interest Rate Cap
There is a real dilemma for borrowers who own a rate cap and are now in a situation – via an extension of the underlying loan – where they need to extend or purchase a replacement rate cap. In the current rate environment, caps are expensive no matter the strike. What’s a borrower to do?
There are a few ways out of the conundrum, but none are easy. First, an obvious choice is to raise the rate cap strike, lowering the cost of the rate cap extension/replacement. It sounds simple, but generally would only be allowed by the lender if the underlying asset is performing well, e.g., a lower LTV, favorable DSCR metrics, etc.. Secondly, negotiate with the lender to allow the borrower to post cash in escrow for the lender in lieu of extending/replacing the rate cap. The downside there is that there will no longer be a rate cap, and the borrower will then be exposed to the full brunt of floating rates. Thirdly, convert the loan to a fixed rate loan. Converting the loan to a fixed rate seems easy enough, however, most bridge lenders don’t have the ability to offer fixed-rate financing. Occasionally we come across an exception: the floating rate lender is a bank. A bank can offer an interest rate swap to synthetically fix the loan, thereby circumventing the need for an interest rate cap, but it’s not a slam dunk. There are numerous hurdles to overcome, but it can be done given the right situation.
While we;re metioning it, let’s highlight a bit on 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:
Still have questions? Contemplating a swap? Contact Us – Derivative Logic