Fed To Markets: Stop Looking Under Rocks

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What You Missed: Long-term interest rates trended lower while equities were little changed for the week after climbing further into record territory. China continued to stiffen its regulatory grip, corporate earnings were impactful, and the Fed said it has more ground to cover before changing its pedal-to-the-metal stimulus policy. Treasury yields continued their descent as the yield on the 10-year note dropped to 1.22% from 1.30% – now sitting at the levels where they traded just prior to the grand vaccine roll-out and passing of the stimulus package in February. Short-term rates, like 1-month LIBOR, SOFR and BSBY, finished the week slightly higher, but remained near record lows. The price of a barrel of West Texas Intermediate crude oil rose from $71.60 to $73.61 as the US Dollar weakened and Gold strengthened. Treasury yield volatility, a key driver of the cost of rate caps and other option-based interest rate derivatives, fell to one-week lows.

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The Fed doesn’t care about your inflation fears. As expected, the Fed concluded its two-day meeting by keeping interest rates in a target range near zero. The Fed said that the economy continues to make progress despite concerns over the pandemic’s spread. The post-meeting statement explained that inflation has risen, largely reflecting transitory factors, and overall financial conditions remain accommodative. The statement also acknowledged that the economy has made progress toward the Fed’s goals, though it will continue its monthly bond purchases at the same pace (READ: no taper for now), specifically stating that the post-pandemic economic recovery has a ways to go before it will consider adjusting its current policy.

In the post meeting press conference – where the real insights into the Fed’s mind are gleaned – Fed Chair Powell pushed aside the idea that the Fed may ease off its purchases of Mortgage Backed Securities sooner than Treasury bonds. The idea has been making the rounds in financial circles of late as a way for the Fed to begin taking the air out of the red-hot housing market. All told, Chair Powell portrayed a sense of cautious optimism: America will continue to recover the lost jobs spurred by the pandemic, and that, while downside risks from the delta and other virus variants will linger, they will be limited.

Our take: As we expected, via its post-meeting statement, it’s clear that the Fed is still assessing whether its self-imposed bar of “substantial further progress” has been met – the prerequisite for easing off the pace and breadth of its $120 billion per month in asset purchases. We suspect the Fed won’t come to a clear conclusion – and communicate it to the world – until at least mid-Q4 and will begin to formally taper in early 2022. Bond markets agree with us, as evidenced by muted moves in Treasury yields after the Fed’s statements. In short, we saw the Fed’s statements as telling financial markets – and especially the financial media – to stop looking under rocks for insights into its future actions where there aren’t any. In short, it’s a recipe for rates across the curve to remain range-bound for a long while. When the time comes, the Fed will go out of their way to over-communicate their intentions to taper, but that time isn’t now.

Sure, it’s fun to guess what the Fed will do next, but what really matters is growth. The US Department of Commerce said that GDP rose 6.5% in Q2, well below expectations of 8.4%. Consumers led the charge in Q2, increasing their spending by 11.8%, following 11.4% growth in Q1, with stimulus checks in hand and vaccinations in arms. Combined with pent-up pandemic savings and powerful wealth effects via a surging stock market, both spending on goods (+11.6%) and services (+12.0%) advanced at a strong clip.

Our take: Despite the growth miss, America’s economy has rebounded and is now bigger than it was pre-pandemic. The gauge of Q2 growth is even stronger than it looks on the surface, with measures excluding trade and inventory drag far outpacing the 6.5% headline gain. The data also showed that we’re back toward peak growth in just in six quarters, a level the Fed – via its regularly published growth forecasts – didn’t expect the economy to meet for three years. The best part? Assuming we aren’t side-swiped by renewed lock-downs from Covid’s Delta variant, the vast majority of economists expect economic growth to keep expanding through year-end. All told, this delayed-tapering and high growth scenario means that inflation will keep running hot at least through year-end. Fun fact: The US economy contracted at a record average annualized rate of 19.2% from its pre-pandemic peak in Q4 of 2019 through the Q2 of 2020, confirming that the COVID-19 recession was the worst, but shortest, ever.

High housing prices finally backfire despite low interest rates. The US Department of Commerce said that sales of new single-family homes dropped to a 14-month low in June, and sales in the prior month were weaker than initially estimated. Sales of new single-family homes fell to an annualized rate of 676k, 6.6% below May’s rate of 724k and 19.4% below the June 2020 level of 839k. The inventory of new homes for sale jumped from a 5.5 month supply in May to a 6.3month supply in June. Last fall, it sat at a low of just 3.5 months.

In addition, 30-year mortgage fixed rates fell back to the lowest level since February, and the 15-year fixed rate set a record low, sending refinancing applications up 9% for the week. Pending sales of existing homes in June, as measured by signed contracts, fell 1.9% from May, according to the National Association of Realtors. Elsewhere, brokers’ commissions posted another decline in Q2 (-9.7%), more than double the drop in Q1. Improvements of existing properties slipped (-2.8%) while permanent site structures (both single and multifamily) posted modest increases.

Our take: Have you ever heard the saying, “The cure for high prices is high prices”? Well, the state of the housing market is the perfect example. Without broad wage increases to serve as an offset, rising home prices, or prices of almost anything for that matter, will eventually simmer down once demand cools due in response to high prices.

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China crackdown, and its impact on US interest rates. Chinese stocks listed in Asia and the US plunged early in the week as China turned its focus on its own tech companies to improve their domestic competitiveness, marking the first major revision of its directives since they were put in place in 2000. In addition, the government has taken aim on foreign IPOs, preferring that Chinese companies list in Hong Kong, rather than the US, to shield domestic companies from foreign corporate compliance. A more recent crackdown on Chinese private education companies suggests that few industries are out of Beijing’s reach, the question now is which industry will Beijing target next.

Our take: China is one of the prime movers of market narratives and short- term bursts of global volatility, which, have and could once again bleed into volatility of interest rates. That being said, history suggests that if China’s turmoil becomes sufficiently acute, the rest of the world may struggle to shrug it off … even if we aren’t there yet. Will China’s moves at reining in sectors of its economy have any real lasting impact on US interest rates over the long run though? We doubt it.

What to Watch This Week: While inflation is certainly a key driver of the Fed’s initiations of tapering or hiking interest rates, what’s more influential these days is the degree to which America’s job creation engine is working at getting the nearly 7 million still unemployed people back to work. As such, the employment report for July – released this Friday – will factor into the Fed’s assessment of when the time is right to pull back on the stimulus throttle.

We suspect that hiring accelerated in July as the supply of available workers expanded, specifically for services jobs, mainly due to the broadening reopening of the economy. We expect that 800k new jobs were created last month, and that the unemployment rate remained steady at 5.7%.

Elsewhere, the July ISM Manufacturing survey (Monday) will show factories red-lining to meet strong demand amid bottlenecks; the Services counterpart (Wednesday) and the ADP employment report (Wednesday) will both signal whether services activity and employment are strong enough to meet expectations for strong economic growth in Q3.

Big Picture: We haven’t written about LIBOR’s transition in a while, choosing to let the dust settle a bit before drawing any conclusions of whether LIBOR’s anointed successor – SOFR (Secured Overnight Financing Rate) – was gaining any real traction; and, further, whether it or some other competitor benchmark – like BSBY – would be the more broadly used replacement for LIBOR.

The past week saw a major development toward the broad usage of SOFR over other competitor benchmarks: Officials overseeing LIBOR’s transition formally endorsed a series of forward-looking term benchmarks tied to SOFR, a move many anticipate will propel its wider adoption across markets. Markets for syndicated corporate loans and collateralized loan obligations have been slow walking their adoption of SOFR due to the lack of a term structure. This is a big deal and last week’s announcement hopes to solve that.  Despite efforts to make SOFR more palatable to lenders, we still believe some lenders will adopt a credit sensitive rate over SOFR.  Give us a call to understand what the implications are if there is a disruption to the credit markets.

We’ll be covering the topic more as the June 30, 2023 deadline for replacing 1-month LIBOR approaches. For now, just know that most new loan agreements contain language that address LIBOR’s sunset, and provide varying remedies for borrowers – some fair, others not so much – and that we’re starting to see new floating rate loans indexed to SOFR, especially among bank lenders. In the meantime, if you need to catch up on LIBOR’s transition, check out our  LIBOR Transtion Webinar Series.

Current Select Interest Rates:

Rate Cap & Swap Pricing:

LIBOR Futures:

Source: Bloomberg Professional

10-year Treasury:

Source: Bloomberg Professional