Fed Pause On Tap
What You Missed
There was little rest for the embattled Fed last week as its fight against inflation remained front and center amid signals that prices remain uncomfortably high. Most financial markets are expecting the Fed to hike 25 basis points at its policy meeting this Wednesday, while signaling that it intends to enter a prolonged pause before it entertains rate cuts. While everyone focuses on rate cuts, there is a growing possibility that the Fed may need to take further tightening action to bring inflation under control, potentially in the form of further rate hikes later this year.
We’re still in the camp that the Fed will engage in a long pause – keeping interest rates higher for longer than most expect – after this week’s rate hike, and likely won’t cut interest rates until late this year at soonest amid ever-present inflation pressures and a mild-recession that begins in the second half of 2023.
Running the Numbers: Rates and Volatility Fall, Reducing Hedging Costs
In a quiet week, rates drifted lower, searching for a catalyst amid a short slate of economic data releases and Fed speeches. For the week, the 2, 5, 10 and 30-year Treasury yields fell .5, 2, 3 and 1 basis points, respectively. The fall in short-term yields released some pressure in the 2s-10s yield spread, a widely watched barometer of looming recession, to -61 basis points, well off its most inverted level (-108) since the 1980’s, briefly seen a few weeks ago. Swap rates on 3-, 5-, and 10- year maturities are each now at least ~54 basis points below their Q1 cycle highs, meaning fixed rate financing, if available, remains on discount.
3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, made up lost ground to trade at 5.09%, shy of its all-time high near 5.12% hit back on March 10th. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, traded flat week over week, at 4.00%. Swaps markets are pricing around 45 basis points in rate cuts before the end of the year, implying a credit contraction or recession will start to bite over the summer.
The SOFR futures market, and the forward curve it projects to the world, implies that 3-month SOFR will peak at 5.10% sometime in June, and expects it to decline over the next year as the Fed eventually eases.
Elsewhere, global equities were flat on the week. The price of a barrel of West Texas Intermediate crude oil fell $4.62 to $77.94., while the US Dollar and gold both weakened slightly.
**Borrrowers: Have you received a notice, like this one from your rate cap bank asking you to contact them to address the LIBOR transition? Contact us before you respond, as making the wrong decision will cost you money.**
Borrowers Beware: The LIBOR to SOFR Transition Is Not Your Friend
We’re being flooded with calls and emails from borrowers who were recently informed by their lender that their LIBOR-based, floating rate loan would be converting to a new floating rate index, SOFR. Don’t be fooled, there is nothing standard or routine about transitioning the index in your loan or transitioning the index in your rate cap or interest rate swap.
Confused or uncertain about how the transition will impact you? Give us a call, 415 510-2100, to help guide you through it with as little damage to your bottom line as possible. Make no mistake, making the wrong decision will cost you money.
Sticky Inflation + Higher Wages Justifies This Week’s Rate Hike
The core Personal Consumption Index (PCE) for March, a key gauge of inflation that measures prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices, increased 0.3% month on month – the same as in February. On an annual basis, the gauge increased 4.6%, slightly lower than February’s revised 4.7%.
The Federal Reserve Chairman’s favorite inflation gauge, the so-called “supercore” version of PCE inflation that excludes gas, electricity, and housing costs for consumers, rose 0.2% in March, a smaller increase than expected. Don’t be fooled however, supercore’s small-ish increase, while encouraging, is volatile. If one zooms out on the data and looks on a on a 3-month, 6-month, and 12-month annualized basis, they’d see the gauge running at a higher pace of 4.7%, 4.7%, and 4.5%, respectively. That’s far higher than the 2% the Fed wants to see and justifies a rate hike this week.
Moving on the consumer’s wages, the Employment Cost Index (ECI) showed that compared to an upwardly revised 1.1% in 4Q22, quarterly growth in compensation for civilian employees increased to 1.2% in the 1Q23, well above what was expected. That amounts to a 4.7% annual growth in total compensation (up from 4.5% prior).
There are probably two reasons for the increase in wages: First, 31 states increased their minimum wage rates at the start of this year, with many doing so by 5% to 6%. Second, employees in the private sector also called for pay raises to keep up with historical inflation.
Our take: Core PCE inflation remains elevated, which will continue to put pressure on the Fed to bring it down further by keeping interest rates high. The acceleration in the ECI highlights the fact that the upward trend in wages isn’t consistent with a fall in inflation, paving the way for a long road ahead in the Fed’s battle against inflation.
Economic Growth is Slowing – Just What the Fed Wants to See
Real gross domestic product (GDP), the widely viewed gauge of economic growth, rose 1.1% in 1Q, lower than the 1.9% expected.
Our take: This second straight quarter of slowing economic growth is just what the Fed wants to see to achieve their aim of price stability. If the slower-growth trend continues without a dovish action from the Fed to counter it, the US economy will enter a recession in the second half of the year.
Signals of a Near-term Credit Crush are Multiplying
First Republic Bank has re-emerged in the news cycle just as worries about mounting pain in the lending system were beginning to fade from view. For the second consecutive week, banks boosted their emergency borrowing from the Fed, an indication of the banking system’s seemingly persistent stress.
The issue is reigniting worries that a credit crunch is already upon us, making the Fed’s job even harder as it attempts to strike the balance between what looks like tighter lending conditions with persistently high inflation.
Here’s a brief breakdown of some emerging signals that imply credit is becoming harder to get:
- More loans trading at distressed prices: Since the end of February, the amount of loans trading at a distressed price – defined as below 80% of face value – has increased by 26% to approximately $127 billion. Comparatively, distressed bonds rose by 10%, to $488 billion.
- Shrinking money supply: The decline in credit availability coincides with a decline in the money supply, a sign that the Fed’s increase in interest rates is forcing money out of the banking system and reducing the amount of available credit. Two weeks ago, the Dallas Fed and the San Francisco Fed both reported increased funding pressures in their respective regions, with projects being canceled and an expected rise in nonperforming loans.
- Woes in the office sector: As job openings increase and more workers opt to work from home, Capital One stated that it set aside more money to cover soured office loans. According to a previous forecast by Morgan Stanley, office property valuations may decline up to 40% from their peak to their trough, increasing the risk of defaults. The leveraged loan market is another increasing source of credit stress as corporate borrowers with floating-rate debt, and lacking appetite for hedging it, struggle to keep up with rising borrowing costs.
- Increasing consumer headwinds: Banks that reported quarterly results in recent weeks claimed they had increased reserves to combat an expected wave of defaults to levels not seen since the early stages of the pandemic. As an example, Capital One also boosted reserves for expected credit card losses by more than 300% to $2.26 billion.
- Increasing chatter about credit on corporate earnings calls: Company executives are discussing credit on conference calls at the highest rate since the pandemic.
What to Watch This Week: Signals of a Fed Pause
Despite ongoing turmoil in the banking system, all indications point to a 25-basis point Fed hike during the conclusion of its policy meeting on Wednesday, raising the Fed Funds rate to 5.25%. In the official meeting statement and the press conference immediately after the meeting, Fed Chair Powell & Company will do its best to imply that this week’s hike will be the Fed’s last for quite some time. Holding rates at their high level while keeping an eye on whether inflation is trending lower will be the next step in the Fed’s tightening cycle.
The Fed’s decision to hit the pause button on rate hikes now is fueled by its belief that its aggressive hiking campaign that began last March will impact America’s economy with a “long and variable lag”, and that more dis-inflationary impacts lay in wait. It’s also likely that the recent banking turmoil in the banking sector will do some of the Fed’s inflation fighting work for it in the form of tighter credit in the coming months. Layer on the high and growing probability of a mild recession later this year, and you have all the reasons you need for a Fed pause.
Or do you?
A mild recession would likely only bring inflation down by 1%, and with core PCE inflation running at 4.6%, and likely only falling to 3.5% by year’s end, it’d still be far higher than the Fed’s 2% target even after a recession.
Although there is a softening in the jobs market, it probably isn’t happening quickly enough to bring inflation down to where the Fed wants it to be. Even though job openings are continuing to fall (JOLTS data, Tuesday), the jobs market is still excessively hot with 1.7 vacancies for every unemployed person. The jobs report for April (Friday) will likely reveal that hiring is still happening at a pace that’s inconsistent with a substantial decline in inflation.
Finally, unit labor costs (Thursday), a measure of wage costs adjusted for productivity, probably increased by around 6% in 1Q due to a probable fall in labor productivity (also Thursday). In other words, firms likely have experienced a faster increase in the cost of labor than the 4.6% core PCE inflation rate. Unit labor costs have historically been a reliable leading indicator of core inflation, and when taken together, imply that core prices will likely continue to rise. That’s the exact opposite of what the Fed wants to see.
If the fall in labor productivity continues, consumer’s wage gains will have to slow considerably, which implies that there would need to be a lot more unemployed people to get core inflation back to the Fed’s 2% objective. To do that, we’d need a much deeper recession than the “moderate” one that we’re expecting. The alternative? The Fed threads the needle by getting comfortable with inflation above its 2% target, sparing the economy from a deep recession.
Finally, when observing the SOFR forward curve, it is clear that markets expect the Fed to cut interest rates as soon as the summer. Compare that to the Fed’s dot plot, which shows that Fed voting members aren’t expecting rate cuts until next year. What gives? It’s a conflicting scenario that will likely resolve somewhere in the middle: Financial markets will back off their extreme view of near-term rate cuts, pushing them out to later in the year, while the Fed gets more comfortable with inflation hovering above it’s 2% target. Time will tell.
Strategy Corner: Fixed Rates are Lower than Floating, is Borrowing Fixed Really an Easy Decision?
Many of our borrower clients have expressed concern about the risk of term rates rising above market expectations when their interest rate cap matures, and how they’ll shoulder the high cost of replacing their rate cap.
Most bridge lenders require the borrower to purchase an interest rate cap to close the loan. A cap’s typical term is 2-3 years. The objective of borrowing at a high credit spread through a bridge lender is to improve the value of the asset, increasing rents or selling the property at a profit. In a low interest rate environment, the economics penciled out.
Less so now. The rise in short-term interest rates has created a significant problem for short-term borrowers. Many borrowers have had to provide more equity to cover the substantial increase in interest rates, anywhere from 0.50% + 5.00%, almost doubling the borrower’s cost of funds.
Once the bridge loan matures the borrower usually has extension options. Some choose to go the route of refinancing via a fixed interest rate term loan via the following types of debt:
- Life insurance
- Bank – usually fixed with an interest rate swap
One big problem the borrower faces when seeking to refinance into a fixed rate term loan is a rise in fixed rates. Fortunately, there is a way to hedge this risk: a swaption. Don’t let the word scare you. A swaption isn’t complex.
Curious? Give us a call to see if a swaption could work for you: 415-510-2100.
Mistakes in financing strategy can be costly down the road, and using an advisor with significant market experience is crucial to guide you through uncharted waters. View an independent study on the topic: Interest rate risk: fixed or floating?
Current Select Interest Rates:
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Source for all: Bloomberg Professional