Fed to Lay Out Rate Cut Game Plan

**Headed to NMHC in San Diego this week? So are we. Text Jim Griffin (310-283-6779) or Scott Croul (949-395-8531) if you’d like to meet.**

What You Missed

A glimmer of the much-hoped for “Goldilocks” economy – where the Fed successfully slays inflation without decimating the economy while simultaneously paving the road for an economic soft landing – could be seen in Q4’s growth, spending, and inflation data released last week. But on the flip side, data as of mid-January indicate a sharp increase in layoffs. With steadily dissipating inflation pressures and economic risks more evenly balanced, we suspect that the Fed will take their time to see how things play out and won’t execute the first rate cut until May.

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Running the Numbers: Rates in Stasis Awaiting Fed for Direction in Pivotal Week

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Interest rates are in limbo until the Fed announces its policy stance on Wednesday. Traders are clinging to bets that Chair Powell & Co. will cut interest rates in March, with about a 50% probability of such priced in. Those wagers strengthened modestly after the key PCE deflator gauge slowed as expected. Persistently high prices for services  underscored concerns that the Fed will signal that it wants to see further progress in its inflation fight before it can truly consider cutting interest rates.

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, held steady at 5.31%. 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 to be a year from now, fell one basis point week-over-week, to 3.66%, reflecting a market in stasis that awaits this weeks Fed meeting for direction.

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 3.34% in December 2025.

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. Remember though that while rate volatility moved lower, it’s still high historically, and his driven rate cap costs down 25-30% across the board. Curious what a rate cap costs? Check out our rate cap calculator.

Elsewhere, equities rose from a week ago as the US economy grew at a faster rate than expected. The price of a barrel of West Texas Intermediate crude oil rose $2.23 from this time last week to $77.44 on the back of rising middle east tensions, as the US dollar and Gold both strengthened slightly.

Q4 GDP Hints at a Soft Landing, But It Isn’t a Slam Dunk Conclusion – Yet

The fourth quarter’s GDP growth surpassed forecasts, increasing at a 3.3% annual rate and boosting hopes for a soft landing. The upside surprise was fueled by building inventories and an improved trade balance, but both have a history of volatility and aren’t expected to support growth in the current quarter. The main driver of GDP growth was still personal spending, which showed an increase in spending throughout the quarter before a spike during the holidays.

Let’s get into it. Real GDP growth dipped to a lower but still logged a respectable 3.3% in Q4 2023 (from 4.9% previously), higher than the 2.0% consensus estimate. Most of the growth was driven by consumer spending, which increased at a 2.8% clip (versus 3.1% prior), showing dimming but still-robust consumption of both goods (mostly non-durable goods, as well as recreational goods and motor vehicles) and services (mostly lodging and health care). Finally, business fixed investment grew at a moderate 1.9% pace (up from 1.4% previously), with structures and intellectual property products leading the way (3.2% and 2.1%, respectively). Business spending on equipment increased by just 1.0%. Core capital investment will probably show a decline in the near term as capital spending plans fall short of historical averages.

Our take: Economic growth expanded more than anyone expected in Q4, increasing optimism that the Fed will finally stick a soft economic landing – while avoiding a recession –  at some point this year. The fly in the pinot? Survey data – like consumer demand and business inventories –  are giving far weaker signals and are on the Fed’s radar more than ever. Additionally, most of the growth seen in Q4 stemmed from volatile categories and government spending, areas that can’t necessarily be counted on to continue in Q1 2024, implying that there’s a strong chance that the Q4 GDP figures will be revised lower in the future. It’s a recipe that gives the Fed plenty of reasons to put off the first rate cut until the Spring.

Core-Inflation’s Decline Sets Stage for Coming Rate Cuts

Inflation’s momentum is slowing even though personal spending and incomes showed strong increases in December. Core inflation’s three-month annualized pace dropped to 1.5%, as the six-month annualized pace held steady at 1.9%, both below the Fed’s 2% inflation target. The data paves the road for the Fed to begin cutting interest rates in the coming months.

Before we go further, it’s time for a review. One often discussed inflation gauge, especially by the financial news media – the Consumer Price Index (CPI) – measures the average price change of a basket of goods and services and is sourced from consumers. The Personal Consumption Expenditures Index (PCE) – which the Fed prefers over the CPI – is sourced from businesses. To better understand price fluctuations, the Fed and economists typically prefer to look at the “core” CPI and PCE inflation data –  which exclude volatile prices for food and energy  – for a more accurate picture of the longer-term inflation trend.

Further, Fed Chair Powell prefers “supercore” PCE inflation, which refers to price measures that omit industries that analysts believe distort the overall inflation picture. Supercore inflation, according to its proponents, paints a more realistic picture of the factors influencing prices beyond transient supply shocks. This was particularly important during the pandemic when supply shocks wreaked havoc on inflation gauges.

Supercore PCE inflation increased to roughly 0.3% (from 0.14% previously), primarily due to the cost of financial services and recreational services. The six-month annualized rate was 2.8% (compared to 2.7% prior), while the three-month annualized rate decreased to 2.1% (from 3.0% prior). All moves the Fed wants to see.

Consumer spending – always important for the inflation outlook since consumers alone are responsible for ~70% of all US economic activity – grew an expected 0.7%.  The flip side to spending – personal incomes, also hugely important for the inflation picture – grew 0.3% in December, down from 0.4% in November and in line with expectations.

Our take: The increase in personal income and spending will give markets hope that the Fed can achieve a soft landing, though it’s far from assured. We anticipate that after the holiday spending extravaganza, consumers will become cautious with their spending since real personal incomes are growing more slowly than spending. The Fed will instead focus on inflation’s momentum, which has been slowing over the previous three to six months. As the Fed’s assessment of the risks changes, the stage will be set for the first rate cut in May.

What to Watch: Fed Policy Meeting and Jobs Data Won’t Clear the Murky Economic Picture

While last week’s consumer spending and inflation data bode well for the possibility of an economic soft landing, recent data prints showing soft economic activity make mapping out the economy’s real trajectory is tough. Initial and ongoing seasonally adjusted jobless claims are rising, and over the last three months, other indicators have shown a weakening of the jobs market in nearly half of all US states. Additionally, the number of US companies announcing layoffs has increased.

Looking ahead, the data slate in the week ahead probably won’t help to clarify the conflicting narratives unfortunately.  The January jobs report (Fri.) will likely show slower job growth, but be careful about reading too much into it, due to the impact of anomalous weather patterns during the period when the data was collected combined with messy yearly revisions to the data. The jobs market is probably cooling rapidly, as just a few industries are the only ones hiring, and the slowdown in employee turnover at companies portends a hiring slowdown in the months ahead. The latest reading of job openings (Tuesday) is likely to reflect the labor market’s cooling trends from previous months, while consumer confidence (also Tuesday) will probably show a rise on the back of falling inflation expectations.

Soft economic data (see explanation of “soft” vs. “hard” data here), on the other hand, is probably going to keep signaling economic weakness. While the financial markets may continue to ignore it, the Fed isn’t, implying that the Fed is a lot less confident than financial markets are that an economic soft landing is truly at hand.

We, along with everyone else, expect the Fed to stand pat on interest rates in its January FOMC meeting (Wednesday), while emphasizing progress in its inflation fight and acknowledging the contradictory signals it’s facing from hard and soft economic data. The highlight of Wednesday’s meeting will be watching how the Fed goes out of its way to lay out its criteria for cutting rates and how it plans to communicate about those cuts and the tapering of quantitative tightening (QT).

Every syllable of Fed Chair Powell’s post-meeting speech will be parsed for clues as to the likely timetable for rate cuts. Any hint that the Fed is leaning toward cuts sooner than later will likely set off a revival of bets of rapid rate cuts. Right now, markets are forecasting the Fed to cut five times this year, in 0.25% increments, whereas the Fed is broadcasting only three 0.25% cuts. This wide gap will have to be reconciled over the course of the year, and we expect markets to reain in their extreme rate cut bets big time.

Strategy Corner: Blend and Extend Interest Rate Swap – How to Immediately Reduce Interest Rate Expense

Does extending the maturity date of an interest rate swap make sense?  If you have an interest rate swap maturing soon, extending the maturity date can lower the current fixed interest rate without having to terminate the existing swap and paying any breakage cost.  Even if the swap has a positive market value, it may be advantageous to extend.  Forward interest rate curves are inverted which means term rates are lower than the floating rates.  This is because the market expects the Fed to cut interest rates in the future.  By extending the maturity date of the swap, the hedger is capturing the curve at the point where short-term rates are lower than current rates.  This means that the hedger can reduce the existing pay-fix swap rate by as much as 50 bps or more.  Curious? Call us to see if extending your interest rate swap makes sense.

Extending or Replacing Your Rate Cap? A Few Things to Keep in Mind

  • In general, rate cap costs are down 25-30% from their peak.
  • If your cap is in-the -money, where its strike is below SOFR’s current level, expect your lender to require the same in-the-money strike on the extension/replacement rate cap, regardless of how the asset is performing. Hoping for a much higher/cheaper strike? Good luck with that outside of a formal refinancing of the loan.
  • Balance sheet lenders are more flexible in rate cap negotiations, CLO funded lenders, much less so.
  • We are routinely seeing lenders allow for the term of the rate cap extension to be much shorter than what is written in the loan agreement, e.g., a 90-day extension versus 1-year, saving the borrower money. Why? Given the broad expectation for lower rates, they’re more comfortable with the rate and price risk.  However, in all cases, the borrower will have to continue to roll the cap every 90 days if the loan remains outstanding.
  • On a construction to mini-perm bridge loan, make sure to work with the lender to allow for the rate cap’s notional amount to sync with the anticipated draw schedule (an “accreting rate cap”). Why pay for “insurance” you don’t need?

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