Expansion Will Soon Run Out of Steam

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What You Missed

The theme for interest rates continues to be one of a guessing game as to whether America’s economy will achieve a soft landing or fall into a mild recession by the end of the year. Woven throughout that theme is ongoing debate about whether the Fed is truly done hiking amid evidence of its mixed success at slaying the inflation dragon. Of course there is constant focus on when the Fed will cut interest rates, which we, and a growing number of market analysts don’t see happening until Q2 of 2024.

In the meantime, the case for an extended pause in the Fed’s rate-hiking cycle was strengthened by economic data this past week. The Fed is indeed making progress against inflation, as evidenced by a softer Consumer Price Index (CPI) reading, falling inflation expectations, and relatively modest growth in the Producer Price Index’s (PPI) less volatile components. The takeaway? The additional 25-basis-point rate hike forecasted by the Fed’s Dot Plot for this year may not be necessary after all, given that consumers are clearly tightening their belts and unemployment claims are rising.

Running the Numbers: Rates Higher Across the Maturity Spectrum

For the week:

  • 2-year Treasury yield: up 17 basis points to 4.93%
  • 5-year Treasury yield: up 16 basis points to 4.34%
  • 10-year Treasury yield: up 9 basis points to 4.18%
  • 30-year Treasury yield: up 1 basis point to 4.28%
  • 1-month Term SOFR: flat at 5.31%

3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, rose just one basis point to 5.37%. 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 25 basis points point week over week, to 4.52%, reflecting the mixed bag of inflation data and view by some in markets that the Fed may not be done hiking 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 5.41% (remember, it’s 5.37% right now), 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, finished the week lower, on the back of mostly higher Treasury yields. Elsewhere, equities were flat on the week as markets digested the conflicting inflation data. A barrel of West Texas Intermediate crude oil fell $0.22 to $82.26.

Inflation Cooled for a Second Consecutive Month, Strengthening Calls for a September Pause

Core CPI – what the Fed really pays attention to – increased by a meager 0.2% month over month in July, matching expectations. Annualizing the data on a 1-month, 3-month, and 6-month annualized basis, a method the Fed employs to gauge inflation’s momentum, the 1-month annualized close to the Fed’s 2% inflation target. That’s good news.

The fly in the rose’? Rising oil prices – up 19% to $83 per barrel since July 1st –  and an unexpected uptick in producer prices – up 0.3% in July – could make August’s inflation readings much less inspiring.

Our take: Increasingly tepid inflation pressures and a weakening consumer outlook will give added momentum to the growing belief that the Fed is done hiking for a long while, and quite possibly done with hiking in this hiking cycle. Cars and other interest-sensitive spending categories are seeing a decline in demand, and core inflation will likely continue to decline as the housing bubble fades. The Fed will continue to concentrate on the core inflation, allowing for a protracted pause in rate hikes beginning at the September 20th Fed meeting, even while headline inflation faces upside risks through year’s end. But will the Fed need to hike again? Maybe the Fed hikes one more time, and maybe they don’t. Either way, we’ll probably have to wait until the run-up to the Fed’s November meeting to find out.

Consumers are Tightening Their Belts

Balances on revolving consumer credit lines, e.g., credit cards, fell in June for the first time since April 2021 to $605 billion. The data is a signal that consumers – who alone are responsible for roughly 70% of all US economic activity –  are beginning to scale back their spending after exhausting their cushion of cash from pandemic- related stimulus. That view was further evidenced by an increase in personal saving rates, which, to be fair, are still historically low despite their recent increase.

Taken together, the data shows increasing signs that high interest rates are starting to bite. When coupled with a rise in loan rejections, it’s becoming clear that consumer spending is under threat.

Our take: Your and my spending on those shiny new things has proven to be the key support for the economy despite high interest rates, thanks to ultra-low unemployment and steady growth in wages. That said, prices remain much higher than they were a year ago for a wide range of goods and services, and it’s becoming evident that household budgets are coming under strain amid rising loan delinquencies. If we’re right, it’s a dynamic that will allow the Fed to pause its rate hiking campaign as more and more signs of economic slowing show up through the end of the year. Think it doesn’t matter? You’re wrong. America’s economy begins and ends with the health of the consumer.

What to Watch: Expansion will Soon Run Out of Steam

Now that inflation pressures seem to be on a sustained cooling trend, the billion-dollar question is: what’s causing it? Is it the Fed’s 500 basis-points in rate hikes finally taking a bite out of the economy, or could it be what some are calling “immaculate disinflation”, the notion that high inflation will decline naturally without inflicting much damage to economic output and employment, thereby avoiding a recession.

If you’re one, like us, who believes that an economic soft-landing – the avoidance of a recession – isn’t assured, there’s a range of views as what could put us in one. According to several forecasters who are predicting a recession, the economy is currently expanding and the Fed’s need to hike rates further will trigger a slump. In contrast, we believe that the jobs market is not as robust as it looks and that the economy is currently rather vulnerable. Why? Knowing that the consumer is the bedrock of the economy, many households have used up their initial Covid-driven stimulus buffer and are continuing their spending patterns by accruing debt, the repayment costs of which are becoming prohibitively expensive because of the Fed’s rate hikes. The reckoning will come when lenders tighten credit standards; something the latest Senior Loan Officer Opinion Survey suggests will occur through the rest of the year.

Some of these weaknesses should come to light via data set for release this week. Retail sales (Tuesday) will reveal that stalling consumer spending is driving up business inventories, implying that inflation pressures will continue to abate. Wednesday’s industrial production data will reflect the manufacturing sector’s ongoing difficulties. Additionally, the housing industry is still struggling, as will be shown via the National Association of Home Builders latest survey (Tuesday), and housing starts and building permits (both Wednesday).

All told, the data will help pave the road for the Fed to hold interest rates steady at its September meeting, and taken with other consumer and business-related data, for the Fed to hold rates steady through 2023.

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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