Fed is Done Hiking – Here’s Why
What You Missed
Financial markets have indeed been touched by the events in the Middle East, which undoubtedly made for many of the weekend’s headlines. There is a growing consensus that the Fed is done hiking in this cycle, as the recent surge in US Treasury yields may have done some of the job of tightening financial conditions for them. Last week’s “blow-out” jobs report whipsawed financial markets and increased speculation on the possibility of interest rates staying higher for even longer. However, there is growing evidence that indicates the job market will become softer in the upcoming months. When combined with a weakening consumer backdrop, high long-term yields, a shaky geo-political climate, all amid sticky inflation, it’s a recipe that will cause the Fed to adopt a more cautious approach, refraining from hiking rates again in this cycle and likely delaying rate cuts until Q2 2024.
Curious where rates are headed through year’s end? Watch our Q4 Interest Rate Outlook livestream, recorded Thursday, October 5th. Click here or email us@derivativelogic.com
Running the Numbers: Long-term Rates Rise to Fresh Multi-Decade Highs
Last Wednesday, the yield on the 10-year Treasury note exceeded 4.80%, reaching its highest point since late 2005. With bond markets closed yesterday for Columbus Day, markets are seeing safe-haven flows into bonds this morning on the back of the geo-political news, putting downward pressure on Treasury yields (more bond buyers = higher bond prices = lower yields).
For the week:
2-year Treasury yield: down 12 basis points to 4.98%
5-year Treasury yield: down 5 basis points to 4.64%
10-year Treasury yield: up 3 basis points to 4.70%
30-year Treasury yield: up 10 basis points to 4.89%
1-month Term SOFR: up 3 basis points to 5.35%
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, rose basis points to 5.43%. 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 19 basis points week-over-week, to 4.80%, reflecting the growing consensus that an eroding US economic picture may be right around the corner and that the Fed is done, or close to done hiking.
How much higher will SOFR rise? 1-month SOFR, via the SOFR futures markets, and the forward curve they project to the world, is expected to peak at 5.45% in January 2024, 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, spiked to levels last seen since May. 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 lower on the week as long-term interest rates continued to rise. The price of a barrel of West Texas Intermediate crude oil fell over $9 to $82.70 as demand for US gasoline slipped and Russia resumed diesel exports. Oil did spike on news of the Israel-Hamas war, to $86.00.
Why the Jobs Market Isn’t as Robust as it Seems
The always-important-for-interest-rates monthly jobs report for September, released last Friday, showed a headline gain of 336k in new jobs, surpassing the previously corrected figure of 227k for August. The number was far above the consensus estimate of 170k. The jobs data for both July and August were revised upward by 119k, adding to the positive vibe.
The household survey (curious why are there two different job surveys and how they differ? click here for a deeper dive) indicated a far-less robust jobs market, with only 86k in new jobs created in September (versus 222k in the month prior). Adjusted to match the nonfarm-payroll methodology, household employment saw a decrease of 7k, (vs. +127k prior).
The 3.8% unemployment rate remained steady in September. Out of the 90k employees that joined the labor force in the month (compared to 736k prior), 86k found jobs while only 5k stayed unemployed. This implies that finding work is still relatively easy for people. Wages (aka average hourly earnings), important for the continuation of consumer’s robust spending habits, grew a subdued 0.2% month over month, the same as in August – but below the 0.3% expected.
Our take: While inspiring on the surface, we caution you against taking too-much positivity from the data. Why? The monthly jobs report is backward-looking and isn’t yet considering the significant tightening of financial conditions and escalating autoworker strikes occurring at present, implying that October’s jobs report will be far weaker than September’s.
The transportation, retail, and wholesale industries – which were the main drivers of the blow-out September job report – will be the most severely impacted sectors in the UAW’s lingering strike, eliminating at least 30k jobs off October’s number. It’s also possible that the increase in longer-term yields since August has resulted in employment losses in interest-rate-sensitive sectors of the economy like finance, notably mortgage financing. As such, the unemployment rate will increase in October with the number of new jobs falling notably, prompting the Fed to hold rates steady for the rest of the year as risks to the jobs market mount in October and November. Rate cuts? Forget about those until early Q2 2024 at soonest.
What to Watch: Higher Inflation to Keep the Fed Uncomfortable
The question over whether the Fed is done hiking rates wasn’t answered by the spectacular September jobs data. A more conclusive view may come from two important upcoming economic indicators on tap this week: the University of Michigan consumer-sentiment survey on Friday and the consumer price index (CPI) on Thursday. CPI will likely come in hotter than the Fed would like due to the high gasoline prices seen of late, and possibility even higher oil prices stemming directly from the Israel-Hamas war, keeping expectations of one-more-rate-hike to stem the inflationary spillover alive.
The next Fed meeting on November 1st is expected to be one of the most challenging in the Fed’s history. The tough question for the Fed now is whether it should try and forecast a future awash with uncertainty or base its monetary-policy decisions solely on data that’s backward-looking (e.g., September’s jobs report). If the Fed chooses to look ahead, which we expect, it will likely give greater weight to the lagged effect of the spike in long-term rates, the strengthening of the dollar and tighter financial conditions resulting from the impending economic shocks emanating from the UAW strikes, a possible government shutdown and of course to spiraling and unknown economic impacts of the evolving Israel-Hamas war.
In total, all are enough – via their negative impact on America’s economy – to substitute for another 0.25% Fed rate hike. Fed Chair Jerome Powell has gone out of his way recently to state that he would rather remain patient in the face of uncertainty. We believe him. If the Fed does skip a rate hike on Nov. 1 to obtain a clearer understanding of the situation, it’s likely that they are done hiking this cycle.
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