Fed Minutes Scream What the Fed Won’t Say Out Loud

What You Missed

In a light data and event week, tech earnings, Fed meeting minutes, and hawkish talk from a parade of Fed speakers dominated headlines as markets continued their rate-cut-timing guessing game, with most now abandoning hope of any Fed rate cut before June. The SOFR yield curve inverted further on the back of news of unexpectedly low jobless claims and growing expectations that interest rates will remain higher for even longer.

Running the Numbers: Rates Mixed in a Quiet Week

Looking for live market rates and historical interest rate data? Check out our Interest Rate Dashboard.

Yields drifted amid a quiet week last week, posting muted moves with little direction, eventually settling slightly below their year-to-date highs. Looking ahead, interest rate markets are preparing for the impact of heavy Treasury and corporate bond issuances this week amid a full calendar of Fed speakers and economic data. The heaviest focus will be on the latest reading from the Fed’s favorite inflation gauge as markets search for any information that helps them better forecast the timing and extent of Fed rate cuts this year. Elsewhere, Fed speakers will likely lean even further into the narrative that has resonated throughout markets of late: that the Fed doesn’t feel pressure to begin cutting rates anytime soon. As such, markets have now fully unwound their expectations of deep near-term rate cuts, and now see a shallow rate cut cycle as the prevailing view, pricing a 58% probability of a rate cut in June, and a total of ~1% in rate cuts by year-end.

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, rose one basis point to 5.34%. 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 – and by extension, hedging costs –  to be a year from now, rose six basis points week-over-week, to 4.20%, reflecting expectations that inflation pressures will remain sticky, delaying any near-term interest rate cut.

How much higher will SOFR rise? 1-month SOFR, via the SOFR forward curve, implies that one-month SOFR has already 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 3.52% in March 2028.

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. Curious what a rate cap costs? Check out our rate cap calculator.

Elsewhere, equities traded in record territory amid renewed enthusiasm over rapid advancements in artificial intelligence. The price of a barrel of West Texas Intermediate crude oil fell $2.27 from this time last week to $76.47, as the US dollar weakened Gold both strengthened.

Fed Meeting Minutes Scream What the Fed Officials Won’t Say Out Loud

It’s been a quiet couple of weeks on the data and event calendar, and as such, Fed-watchers – us included – are stumbling back to some of the darker corners of Fed actions for clues on what the Fed is thinking.

Minutes from the Fed’s January 31st monetary policy meeting, released last week, suggest that the Fed’s voting members were largely in agreement in postponing interest rate cuts. While we won’t bore you with the details of the minutes, just know that one glaring omission caught our eye: guidance about the conditions the Fed wants to see before pulling the trigger on the first interest rate cut.

For instance, the minutes did not expressly state that officials are “confident” that inflation is headed in the right direction, a widely believed condition for any near-term rate cut. Instead, they highlighted potential hazards that could prompt the Fed to keep rates high for even longer. This is in sharp contrast to Fed Chair Powell’s comments in his post-meeting news conference, where he stated that Fed officials are “already confident” that inflation is sustainably headed in the right direction but needed more confirmation of such before pulling the rate-cut trigger.

Our take: This tells us that, when editing the meeting minutes, Fed officials chose to use some discretion in emphasizing talks that support their message of interest rates staying “higher for longer” while downplaying their growing confidence that inflation is indeed moving in the right direction or concerns  about downside risks to the economy. Expanding on that assumption, given the equity market rally this year, and the fact that consumer’s wage growth (4.5%  YoY) is still higher than the inflation rate (3.1% CPI, YoY) – maintaining their disposition to spend and keep inflation uncomfortably high in doing so – the Fed’s stance makes sense. However, it also implies that the Fed likely stands ready to pivot toward cuts for real if the economy shows signs of tanking.

Layoffs are Spreading, But Quietly. What Does it Mean for Rates?

Although there were many layoff announcements at the beginning of the year due to seasonal restructuring and cost-cutting measures, January’s jobs report, which measures employment on a national level, was surprisingly strong. Peeling back the onion, state-level jobs data is painting a less robust picture, implying that rate cuts may not be as far off as the recent blowout jobs report implies.

According to a report from Challenger, Gray & Christmas, Inc., a job consultancy firm, since the middle of 2023, the number of states with a higher unemployment rate than the year prior has been rising. By December of 2023, nearly 60% of states had a growing pool of unemployed, up from 32% last August. By industry, technology accounted for 40.6% of all layoffs last year, the largest of any industry. In January, that percentage fell to 19.2% of the total, with food and retailing taking third place at 14.6%. Financial services took first place in the most job losses last month, accounting for 28.2% of all layoff announcements. Overall, this year saw the second-highest number of job cuts announced in any January since 2009.

Why you should care: The broadening of job losses across industries feeds into persistent skepticism of the robustness of the jobs market as implied by January’s blow out jobs report. The next read on state-level employment comes on March 11th, right after the March 8th release of the February jobs report, which we expect to show some payback from January’s strong jobs number. If the state-level jobs data proves to be an accurate indicator of the strength of the jobs market nationally, and our expectations of greater weakness in both comes to fruition, a nearer-term Fed rate cut may come to pass.

What to Watch: More “No-Landing” Signals to Emerge

As the stock market continues to log record highs, interest rate watchers are talking more and more about a “no-landing” scenario for the US economy, where economic growth continues unabated amid persistently high inflation pressures, and a Fed that’s content to keep interest rates high.

It’s becoming increasingly difficult to disagree that a “no landing” scenario may be just where we’re headed. Consumer sentiment has turned up in recent months (consumer confidence, Tuesday; Univ. of Michigan consumer sentiment index, Friday), the manufacturing sector is emerging from a difficult year (ISM Manufacturing Index, Friday), and inflation pressures (core PCE deflator, Thursday) after accelerating in January, likely remain stubbornly high.

If PCE inflation comes in above the 0.4% expected, it will lead markets to push out their projection of the first rate cut beyond June 2024. It would also support the theory that economists have been misdiagnosing the impact of high interest rates on the economy, and imply that bond yields are lower than they should be. It’s also possible that high interest rates just aren’t as strong of a brake on economic growth as they once were, given that many corporate borrowers took advantage of cheap funding during the pandemic. At the end of the day, Inflation pressures may have moderated simply because supply chains returned to normal and fiscal stimulus faded.

Given the run of better-than-expected economic data of late, is an economic slowdown really in the cards at this point? If you like the idea of lower interest rates, you had better hope so. One way to gauge where we’re headed is to observe the lagging impact the Fed’s 5%+ in rate hikes has had on different sectors of the economy.

The lagging impact of higher interest rates tends to be shortest in the housing and manufacturing sectors, which have seen notable improvements in their fortunes of late.  However, for the credit and job markets, the lagging impact tends to be longer. With the rate of job resignations now below their pre-pandemic level, combined with a decline in working hours and in the need for temporary workers, the jobs market may be beginning to show increasing signs of strain. The possibility of a looming government shutdown amid a dysfunctional Congress is another factor that could derail a “no-landing” scenario. While any shutdown would have a short-term impact on the economy, the bigger blow would come from the loss of the America’s AAA rating from Moody’s, which may raise the cost of the US Treasury’s long-term financing and would certainly be a drag on economic growth.

Since the Fed’s pivot toward rate cuts back on December 13, consumers have become much more optimistic about the economic outlook. Combined with near record-high investment grade and high yield bond issuance, and more IPO and M&A activity since December, it shouldn’t be a surprise that employment and inflation rebounded in January and jobless claims remain low.

The last mile to the Fed’s 2% inflation target is harder not because of some structural feature in the economy, but because the Fed is afraid of cutting rates too soon, triggering a reacceleration in growth and inflation. That is why the Fed will keep rates higher for longer than markets expect.

Strategy Corner: Interest Rate Swaps

In our recent client discussions, we’ve observed an increase in floating-rate loans from banks being used as financing, and along with them, interest rate swaps being used to fixed the rate. New to swaps? Here’s the skinny:

Only a bank can provide an interest rate swap, and the underlying loan must also be with the bank (there are exceptions, but the costs can be prohibitive).

A swap is used to synthetically fix a floating rate loan. Key considerations and benefits of a swap:

    1. The swap can have a term less than the maturity date of the loan.
    2. The borrower can determine the amount of the hedge. A 50% fixed and 50% floating is considered “risk neutral”.
    3. A swap can have a positive or negative market value over time and can be terminated prior to its maturity. If the existing swap rate is lower than current market swap rate with the same the remaining term, the swap has a positive market value and conversely a negative value if the fixed rate is higher.
    4. The bank must underwrite the exposure in the event there is a default. Unlike an interest rate cap, a swap is an obligation to pay a fixed rate in return for the floating index.
    5. There is an embedded swap fee to compensate the bank for the underlying default risk. This swap fee is fully negotiable, but the borrower/hedger typically has no idea what’s “reasonable”.  Employing the advice of an independent swap advisor is the only way to evaluate what an equitable fee should be.  Many factors play into the determination of the swap fee, and the process can be complex.
    6. Unlike an interest rate cap, which is always an asset, a swap is an obligation of the borrower, and they can’t just walk away from it if the underlying loan is paid off prior to maturity.

Prior to entering into a swap, the hedger must sign a document that sets the legal terms of the swap, a.k.a. the Schedule to the ISDA Agreement. Simply put, the Schedule to the ISDA is used to determine and manage the risks of a default. While these terms aren’t simple, they are negotiable. While you probably won’t remember reading this a week from now, remember this: NEVER, EVER sign the ISDA without proper review by an independent party.  The default language almost always favors the bank.

By fixing the entire loan balance up to the maturity date might seem the prudent way to mitigate floating interest rate risk. Often hedgers don’t consider factors that could result in substantial economic costs. Instead of mitigating interest rate risk, a borrower could be unknowingly adding risk.  Our recommendation? Always seek independent advice.

To learn more about interest rate swaps give us a call or schedule a Derivatives 101 session.

Click to check out our Market Data pages and Calculators

Interest Rate Dashboard
Forward Curves
Interest Rate Cap Calculator
Defeasance Calculator
Yield Maintenance Calculator