Fed Working Hard to Kill Your Rate Cut Dreams

What You Missed

Data and events over the past week painted a murky picture of just where our economy is heading.  An upside surprise in personal incomes and a jump in the Fed’s favorite inflation gauge, combined with stock market rallies all served to justify the Fed’s higher-for-even-longer stance on interest rates. Offsetting that narrative, however, was news of softer consumer spending growth and a weaker manufacturing sector, both helping to evaporate hopes of a “no landing” scenario, where the economy continues to grow at or above trend, even as the Fed takes measures to control inflation through interest rate hikes. We suspect that the economy will eventually slow enough for the Fed to be comfortable cutting interest rates in June at soonest.

Are you wondering where rates are headed in 2024? Watch our insightful and crisply presented Q2 2024 Interest Rate Outlook livestream on Friday, March 22nd, at 10 am PT / 1 pm ET.

You’ll quickly learn what’s moving the interest rates that are critical for you and your investments. And, you’ll be able to get questions answered by our interest rate experts, live!  Save the date in your business calendar today.

Running the Numbers: Rates Lower Amid Crosscurrents

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Yields drifted lower amid conflicting economic crosscurrents last week, settling  below their year-to-date highs. Looking to the week ahead, interest rate markets are preparing for the impact of a busy week full of tier-1 economic data and events. The heaviest focus will be on the January jobs report, with most expecting a payback from December’s blowout number.  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 62% 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, fell two basis points to 5.32%. 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, fell ten basis points week-over-week, to 4.16%, implying that the dream of rate cuts is still alive and well.

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 3.48% in July 2027.

Where is the 10-year Treasury yield headed? The 10-year Treasury yield forward curve implies that the yield will bottom at 4.09% in November of this year – it’s sitting at 4.23% right now –  then stage a slow and steady sequential rise. We suspect that a 10-year Treasury at 4% – assuming the Fed is ultimately successful in getting inflation down to its 2% target – will be Fed Chair Powell’s legacy.

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, now sitting at a monthly low. Rate cap costs continue to hover 25-30% below their peaks. Curious what a rate cap costs? Check out our rate cap calculator.

Elsewhere, equities were flat on the week, with markets looking ahead to important economic events this week such as updated purchasing managers’ indices, the jobs report and a European Central Bank meeting. The price of a barrel of West Texas Intermediate crude oil rose $2.31 from this time last week to $79.88, as the US dollar traded flat and Gold strengthened.

Mixed Signals Will Keep the Fed on Hold into the Summer

Headline Personal Consumption Expenditures (PCE) inflation rose 0.3% and core increased to a 0.4% monthly pace in January (vs. a downwardly revised 0.1% prior for both). Year-over-year, headline PCE inflation fell to 2.4% (vs. 2.6% prior) and core to 2.8% (vs. 2.9% prior).

Supercore inflation, which measures core services excluding housing rents, and is Fed Chair Jerome Powell’s preferred inflation gauge, increased sharply to 0.6% month over month in January from 0.3% in the previous month. Year over year, the indicator grew 3.5% (vs. 3.3% prior).

January saw a staggering 1% increase in nominal personal incomes, which added upward momentum to inflation. That increase came from two sources: a 3.2% yearly cost-of-living adjustment for Social Security recipients, and a jump in personal dividend income, via the January stock market rally. Despite this, real personal spending growth decreased in January by 0.1% (versus an upwardly revised +0.6%), with less spending on goods, which can be traced back to a spate of frigid weather in much of the country in January.

Bottom line: The numbers tell a tale of a Fed battle that has yet to be won. The conflicting signals of strong income growth, low spending, and quickening inflation that were observed in January’s personal income and expenditure report would make anyone’s head spin. Considering the rapid growth in incomes, how could spending be so weak? How could inflation pressures spike if spending was so lukewarm?

Cutting through the fog, it’s likely that several one-off factors are at play, including weather effects driving weak spending, cost-of-living adjustments driving income gains, and residual holiday spending and rising portfolio management fees from the financial services sector is keeping inflation high.

Though the hot inflation and income prints won’t give the Fed confidence to cut interest rates anytime soon, they’ll likely discount them some as they search for consistent signals that consumer spending is declining as household balance sheets worsen and the jobs market softens in the coming months.

For now, a resilient jobs market and solid income growth (average hourly earnings, 4.5% year-over-year) running well ahead of inflation (CPI, 3.1% year-over-year), there seems to be no real danger that consumers, who alone are responsible for ~70% of all US economic activity, will hit a wall anytime soon, likely keeping inflation stubbornly high in the months to come. However, there are signs of stress picking up, with delinquencies on payments such as credit cards and auto debt on the rise. But as the latest data show, it just isn’t yet enough to derail consumption, and that probably has much to do with a resilient jobs market.

Given the mixed economic signals, we don’t see the Fed cutting rates until June at the soonest, and maybe not even then.

Cloudy Outlook for Manufacturing

Given the murky picture on the demand side of the economy, one would hope that there would be greater clarity on the supply side. Unfortunately, that clarity doesn’t exist at present either.  The ISM Manufacturing Purchasing Managers Index (PMI) –  a widely watched gauge of the health of the manufacturing sector which assesses factors such as new orders, production levels, employment, supplier deliveries, and inventories, fell to 47.8 in February from 49.1 prior – well short of the widely expected 49.5. The U-turn reflects consumers becoming more discerning in their spending habits.

Our take: The ISM Manufacturing PMI’s dour signal stands in sharp contrast to recent regional Fed surveys and another, competing read on the manufacturing sector – the S&P Manufacturing PMI – which both showed improving conditions. Which data sets should you believe? It’s tough to tell. However, despite the ISM’s lower numbers, survey respondents expressed a stable business outlook. Regardless, such a mixed picture gives the Fed yet another reason to hang back and settle into their “wait and see” stance on rate cuts even more than before.

What to Watch: Chair Powell to Hammer Home  “No Rush to Cut” Mantra

Hopes of a “no-landing” scenario for the economy are gaining traction, but recent data suggest that the long, variable, and lagging impacts of the Fed’s 5%+ in rate hikes are still working their way through the economy. One example of such are the credit markets, where many expect the lags to be the longest. However, resurfacing worries about the stability of New York Community Bancorp, and, by extension, US regional banks highlight the continuous strains from tight monetary policy.

Furthermore, the weak ISM manufacturing print suggests that ripple effects of foreign monetary policy have the potential to sabotage a rebound, even in a sector where lags from monetary policy are usually short. High interest rates have caused Japan, the UK, and Sweden to fall into recession, as China and Australia – two nations that hardly ever have recessions – are going through bouts of slow growth of their own.

The jobs market is another area that hasn’t fully adjusted to high interest rates. The jobs report for February (due this Friday) – the single most impactful piece of economic data on interest rates – may still indicate a robust hiring pace, but it’s likely that a large portion of that momentum can be attributable to seasonal factors. We’re expecting a slower pace of hiring (185k) than the blowout momentum seen in January (+353k), but one where new job creation is still well above the Fed’s “neutral”, 100k per month pace. Friday’s report will also show that, as more people enter the labor force and as household employment has shown more volatility than headline payroll gains, the unemployment rate could rise to 3.8% from January’s 3.7%. Finally, we’re guessing that wage growth suffered in January, as layoff announcements continue and workers’ confidence declines.

Elsewhere, job openings (Job Openings and Labor Turnover Survey,  Wednesday) likely declined in February, which points to more cooling in the jobs market. Regional Fed business surveys (Fed Beige Book, Wednesday), will likely back up our expectation of a softer jobs market, by showing that companies are hiring with greater caution and are viewing a wider pool of job applicants.

In the meantime, Fed Chair Jerome Powell will exude a cautious tone in his semiannual testimony before Congress (Wednesday and Thursday), putting the world on notice, once again, that the Fed is in no rush to cut interest rates as inflation and income data increasingly show the stimulative impact fueled by his pivot to rate cuts back in December. The reason? The Fed probably feels that the economy is on solid ground, and there’s still a path for inflation to eventually fall to the Fed’s 2% target.

Given the mixed economic signals of late, the Fed is choosing to let the lagged impacts of higher rates continue to work their way through the economy. That means that any resurgence of the sectors of the economy most impacted by interest rates, e,g, credit, will likely be delayed.

Strategy Corner: Rate Caps and Accreting/Amorizing Credit Facilities

We’ve noticed a shift in lender required interest rate caps to accommodate an accreting or amortizing credit facility.   Most term sheets state that the notional amount of the rate cap must be the same as the fully committed loan amount. However, there is a negotiation to be made to sync the rate cap’s notional with the loan’s draw or amortization schedule, as structuring the rate cap as such can yield significant cost savings. We recently priced an “amortizing” rate cap, and the cost was 50% less expensive than a rate cap where the notional is the fully committed loan amount. We asked this particular lender why after so many years of requiring a rate cap for the fully committed loan amount they are now taking into account accreting/amortizing schedules.  Their Answer? “To be more competitive.”

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