Fed Isn’t Coming to the Rescue

What You Missed

Although the unemployment rate rose, America’s job creation engine’s performance in May exceeded the most optimistic forecast. Hold off on breaking out the rose’, though. Coupled with a disappointing read on manufacturing and job turnover, markets viewed the data as a net negative for the economy. The billion-dollar question now: How will the continued stream of mixed economic data impact the Fed’s plan for interest rate cuts?

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Running the Numbers: Rates Spurring Slightly Lower on Encouraging Inflation Data

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The market’s hopes for a near-term interest rate cut were crushed anew by surprise strength in the jobs market, which left us all – once again – with the realization that interest rates will remain higher for longer.

Traders and economists across the spectrum of Wall Street banks dialed back their expectations for the Fed’s first rate cut, translating into a surge in Treasury yields late last week.   Swap markets retreated from expectations for two rate cuts this year – one 0.25% cut in September and another 0.25% cut in December – to just one in December.

Looking to the days ahead, it’s likely that yields will head higher over the course of the week, mostly in the front end of the yield spectrum (e.g., the 2-year Treasury yield). Uncertainties about the state of inflation and the possibility of a seemingly more aggressive Fed (e.g., number of cuts implied by the dot plot) should keep upward pressure on yields.

For the week:

Where will SOFR be a year from now? 3-month (CME) Term SOFR, a valuable gauge for the true cost of interest rate hedging, fell just under a basis point to 5.33%. The implied yield on the 3-month SOFR futures contract 1-year forward (June ‘25), an estimate of where markets expect 3-month Term SOFR – and by extension, hedging costs – to be a year from now, rose five basis points week-over-week to 4.50%, reflecting higher Treasury yields and now collapsed hopes for more than one rate cut this year.

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 in early 2025. The forward curve projects that 1-month Term SOFR will steadily decline from here, eventually bottoming out near 3.68% in May 2028, down five basis points from this time last week.

Where is the 10-year Treasury yield headed? The 10-year Treasury forward yield curve implies the yield will bottom out at 4.32% in May 2025 and then stage a slow and steady sequential rise. With the tug of war between the constant debt issuance from the US Treasury coupled the allure of US government debt (other central banks are now cutting interest rates, making US yields look attractive), there’s little reason for the 10-year Treasury yield to fall below 4% anytime soon. Ultimately, we believe Fed Chair Powell’s legacy will be a 10-year Treasury yield somewhere between 4% and 4.5%.

While the forward curves for SOFR and Treasury yields aren’t forecasts – they’ve proven to be a horrible predictor historically – they give one a peak at the market’s current thinking.

When will rate cap costs decline? Rate volatility, a vital driver of the cost of option-based interest rate hedges like rate caps, was flat week-over-week, holding near a two-week low. Rate cap costs continue to hover 25-30% below their peaks and will likely continue their slow, downward path as the road toward the Fed’s first rate cut gets shorter.

Are you curious about what a rate cap costs? Check out our rate cap calculator. The calculator is a valuable tool for providing an estimate, but if the expected start date is a couple of months away or the cap’s notional amount is amortizing/accreting, give us a call at 415-510-2100 for indicative pricing based upon the specific economics.  Cap costs can vary widely – as much as 40% – when considering changes in the notional schedule or “step-up” strike structures.

Elsewhere, equities are holding just below the record-high levels set early last week. The price of a barrel of West Texas Intermediate crude oil fell $1.28 to $75.53 as the US Dollar strengthened and Gold weakened, spurred by higher Treasury yields.

Murky Jobs Data Splitting Rate Forecasters into Two Camps

As we expected, the May jobs report showed contradictory views of the health of the jobs market: The headline survey showed a robust 272k new jobs created in the month but a higher unemployment rate, 4%, while the household survey painted a very different picture, showing a loss of 408k jobs.

With such opposing signals, it begs three questions: 1) Why are there two monthly employment measures?  2) Which is the best at showing the true health of the jobs market? And 3) Which is the Fed’s favorite? While the answer to the first question is widely understood and reasonable, the answers to the second and third questions are anything but and are the topic of heated debate.

As we explained last week, the headline survey better reflects the state of the economy right now. However, the household survey measures a broader swath of employment, offering a wider insight into the job market, demographic trends, and where the economy is headed in the coming quarters.

As for answering question #3, no one knows which survey is dearer to the Fed. We’d venture to guess that they waffle between the two, depending on where we are in the economic cycle. In times of economic expansion, like what we’re in now, they likely put more weight on the headline job survey, and its consistent outperformance – likely, one of the main reasons why the Fed has chosen to delay rate cuts this year.

Wrapping up the jobs report, average hourly earnings (aka wages) increased by 0.4% in May, surpassing 0.2% in April and exceeding the forecasted 0.3%. Higher wages provide a tailwind to consumer spending and by extension, more intense inflation pressures.

Bottom line? Depending on whom you ask, the May jobs report has the potential to support arguments for both imminent rate cuts or for no rate cuts at all. We’re still in the “no rate cuts anytime soon” camp, believing that the Fed, given static inflation pressures over the last year, sees the blowout headline jobs number as too rich to consider cutting interest rates anytime soon.

Further, we’re still watching other, less talked about barometers to guide our view on where rates are headed. Specifically, the interplay between wage growth and inflation: if year-over-year wage growth (4.1%) runs higher than the year-over-year inflation rate (YoY CPI 3.4%), the mighty US consumer  – who alone drives ~70% of all US economic activity – has the impetus to continue spending, keeping inflation pressures stubbornly high. Layering on strong headline job growth and ongoing signals of loose financial conditions, it’s clear to us that the Fed has zero reasons to seriously consider cutting interest rates anytime soon.

Looking ahead, given the increase in average hourly earnings and economic growth, the financial market’s attention has shifted towards inflation. Pay attention: last week’s jobs report showed more evidence that companies are still able to transfer increased costs to consumers, keeping inflation pressures alive, and likely furthering the Fed’s resolve to hold off on interest rate cuts.

Want to hear our latest views on interest rates? Sign up for our Q3 Interest Rate Forecast Webinar on June 25th.

What to Watch: Fed to Imply Two Rate Cuts On Tap for this Year

It’s time for the next Fed policy meeting, and the trillion-dollar question is whether interest rates are high enough to tame inflation without tanking the economy. The contrasting narratives presented in the May jobs report, with strong payroll gains on one side and rising unemployment on the other amid stubbornly high inflation, will keep driving us all out of our minds as the Fed rate-cut guessing game is set to continue.

While no one expects the Fed to hike or cut rates at this week’s meeting, all eyes and ears are focused on how the Fed’s views on employment and inflation – its two mandates – may have shifted since its last policy meeting, and how any shift in view may impact the timing and degree of any rate cuts this year.

According to the minutes of the Fed’s last meeting on May 1st, the Fed anticipates that the unemployment rate will peak before the end of the year and then gradually decline by year’s end. If that’s still the Fed’s view, then it’s likely unconcerned about the unemployment rate rising to 4.0% in May, the level forecasted in its March Summary of Economic Projections (SEP).

Lucky for you, as part of Wednesday’s Fed meeting, we’ll get a refreshed SEP, and everyone and their dog will scour it for clues of what the Fed is thinking, specifically where it sees interest rates headed via the revised dot plot. We suspect the Fed will imply that it expects to cut interest rates twice this year, beginning in the fall, down from the three projected by the previous dot plot. When you hear “dot plot” “dot plot” dot plot” all over the financial news this week, remember that it has proven to be a terrible predictor historically of where interest rates are headed, but financial markets are always desperate for any insight they can get from the Fed, thus focus on it intently regardless.

Upcoming inflation data (consumer price index, CPI, Wednesday, and the producer price index, PPI, Thursday) will be crucial in shaping the Fed’s decisions, and is the real star of the show this week. Digging in to what’s expected, the recent decline in energy prices – down 3.5% on a seasonally adjusted basis in May – brings good news for consumers and the Fed, and will help take some of the sting off of what, at the end of the day, will be seen as a higher inflation environment. Monthly headline inflation likely slowed to 0.1%, as the year-over-year change is projected to drop to 3.3% (compared to 3.4% previously).

The real story is in core CPI however, which is expected to show a 0.3% increase on a monthly basis and 3.5% on a year-over-year basis, slightly lower than the previous 3.6%. That’s not what the Fed wants to see. As mentioned previously, there is no clear reason for inflation to fall much closer to the Fed’s 2% target before year’s end, as the shelter component of CPI remains stubbornly high, and downward momentum in prices for goods and services wanes. As such, inflation data alone won’t be sufficient to support the argument for cutting interest rates this year.

That leaves only the jobs market to spur the Fed into cutting action, and by the looks of May’s jobs report, we’re still a long way from any real, sustained weakness in jobs. The signal could come in the form of downward revisions to previous job reports, which isn’t likely to be seen until the fall at the soonest. As such, we don’t expect the stars to align for rate cuts until late this year, say November at the soonest. The Fed just needs more time to gain confidence that inflation is truly at bay, which simply won’t come anytime soon.

Strategy Corner: Customized Rate Cap Structures Yield Great Savings to Borrowers

We are seeing new bridge borrowing with required caps at strikes that are more in line with the market.  Many bridge facilities have accreting/amortizing schedules, which should be considered when structuring the cap.  Don’t fall asleep on it; a borrower can achieve substantial savings by using that same accreting/amortizing schedule with the rate cap.  We’ve helped numerous clients work with the lender to accommodate such.  A “step-up” cap is another reducing cap cost strategy.  For example, the first 2 years of the cap is struck at 5.00%, and the last year is 6.00%.   The last year of the cap is the most expensive, hence the higher, 6% strike brings down the overall cost of the cap dramatically.  Curious? Call us to discuss your unique situation.

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