Fed’s Last Hike Will Come In July

Straight to Smart thumbnail

What You Missed

The Fed did its best to pull off a “hawkish skip” by holding rates steady while presenting a more pessimistic Summary of Economic Projections that showed another likely rate hike at its next meeting in July. Markets, however, remained pessimistic: despite a decline in headline CPI inflation, slowing retail sales and industrial output, along with the highest level of jobless claims since October 2021, markets still expect just one more rate hike this year, rather than the two indicated by the Fed’s updated dot plot.

Running the Numbers: Reflecting Higher for Longer

Rates across the maturity spectrum  were mixed, with short-term rates moving higher, and long-term rates trading flat or lower. The crosscurrents of a persistently robust jobs market, stubbornly high inflation, and a Fed that seems to be near the end of its tightening cycle continue to dominate. For the week, the 2, 5 and 10-year Treasury yields rose a respective 15, 10 and 4 basis points. The 30-year Treasury yield fell 4 basis points. Pressure persisted in the 2s-10s Treasury yield spread, a widely watched barometer of recession potential, to trade at -98 basis points, at the higher-end of the recent range of -108 of a couple of months ago and -55 seen a month ago.

3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, fell 3 basis points to 5.22%. The implied yield on the 3-month SOFR futures contract 1-year forward (June ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, rose 24 basis points week over week, to 4.49%, reflecting the ongoing uncertainty surrounding the probability of more Fed rate hikes through the summer and fall.

The SOFR futures market, and the forward curve it projects to the world, implies that 3-month SOFR is already near its peak, and expects it to peak in the fall, at 5.33%, then decline consistently over the next year as the Fed eventually eases. Swap markets are standing firm in their prediction of rate cuts by the end of this year, now barely pricing one rate cut – back from 60 basis points in cuts a few weeks ago – before the end of the year, reflecting the seeming resilience of the US economy, but one that falls into a recession in the fall.

Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, fell throughout the week. Elsewhere, equities had the strongest weekly performance in months, led by US technology stocks. The price of a barrel of West Texas Intermediate crude oil slipped to $70.99, while the US Dollar and gold both weakened.

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.

Key Takeaways from Last Week’s Fed Meeting

At its meeting on June 14, the Fed kept the federal funds rate at 5.0% – 5.25%, but via updates to its dot plot, revealed that most Fed committee members now expect two additional rate hikes of 25 basis points this year. The median prediction, via the revised dot plot, is for the federal funds rate to be at 5.6% at the end of 2023 (it’s 5.25% now). That’s up 0.50% from the prior estimate of 5.1% back in March.

The median projection for year-end 2023 core PCE Inflation was revised up to 3.9% from 3.6% in the latest Summary of Economic Projections, while the median forecast for headline PCE inflation was lowered to 3.2% from 3.3%. This year’s real GDP growth forecast was raised from 0.4% to 1.0%. That looks to be made easier by a more optimistic outlook for the jobs market, as the median projection for the unemployment rate was reduced from 4.5% to 4.1%.What’s it all mean? The Fed isn’t expecting a recession this year.

Our take: We doubt the Fed will hike twice more this year, and believe that we’ll see only one more hike, by 0.25%, in July. Why? The Fed is using the dot plot as a jawboning tool, and it’s using it this time around to prevent markets from drawing the wrong conclusions from its decision to keep rates steady last week. The dot plot is a result of individual Fed committee members’ inflation predictions, and how the Fed could react to them.  They’re predicting higher inflation through the rest of the year, and hence two more Fed rate hikes to combat it. However, we suspect that by year’s end, inflation will likely be lower than these predictions, and that the Fed will end up hiking interest rates less than what the newly revised dot plot implies. If we’re right, we should also see rate volatility fall in short-term interest rates, which would equate to a slow but steady fall in the cost of interest rate caps.

Public Service Announcement: Beware of the Fed dot plot

We’d like to take an opportunity to re-state our opinion of the Fed’s much analyzed dot-plot. If you’re not aware, the Fed’s dot-plot, published each quarter, is a collection of Fed committee members’ individual projections for where the Fed funds rate – the rate the Fed raises or lowers in its hiking or cutting activity – will be in the coming quarters. Each Fed committee member is represented by a single dot at each time point, but each dot is anonymous. Usually, the financial media’s consensus reporting of the Fed’s outlook for interest rates in any given year is the median of the dots that show up on the dot plot. For years now, market analysts and the financial media obsess over the dot plot each time it’s published, many going so far as stating that it’s the Fed’s way of signaling its expectations of future interest rate changes to the world. Last week’s plot was no exception.

Our view? The dot plot is hogwash. It doesn’t represent a central forecast from a committee, it is simply the distribution of 18 individual forecasts for an annual level of interest rates. Fed Chair Powell has said as much in the past, going out of his way to state, “….the dot plot are individual projections, not a forecast, not a plan….the dots are not a great forecaster of future rate moves…the dots are to be taken with a big grain of salt.” Bottom line: Despite what the financial news media will have you believe, the dot plot doesn’t matter – ignore it – what the Fed Chair thinks and says, does. What you should pay attention to is how markets react to revisions in the dot plot, because even though the dot plot usually turns out to be dead wrong at predicting interest rates in hindsight, markets do react to it in the short term.

Inflation Pressures are Moderating – Just What the Fed Wants to See

The headline Consumer Price Index (CPI) – the most watch indicator of inflation –  increased only 0.1% month over month in May (vs. 0.4% the month before), and core inflation increased  at 0.4% again. On a year-over-year basis, core inflation increased 5.3% (vs. 5.5% prior) while the headline increased 4.0% (vs. 4.9% prior).

Our take: The details in the CPI data reveal some development in what the Fed hopes to see: Rent price increases – one of the biggest reasons inflation is high and staying there – have slowed, and disinflation is expected to continue through the rest of the year.  However, your dreams of rate cuts will soon turn into nightmares. While May’s CPI data gave the Fed breathing room to skip a rate hike this month, it’s increasingly unlikely that the Fed will cut interest rates this year given how slowly core inflation is falling. If they do cut by year’s end, it won’t be by much.

Inflation Expectations Support View that Rates Have Nearly Peaked

The University of Michigan’s preliminary consumer-sentiment survey for June revealed the biggest percentage-point decline in year-ahead inflation forecasts since December 2008.

Despite the announcement of OPEC+ oil production cuts in April, which would normally raise gasoline prices but, to-date, haven’t, consumers’ expected rate of inflation decreased from 4.2% to 3.3%, the lowest level since March 2021. Why you should care: Expectations of more modest inflation imply that the Fed won’t feel as pressured to hike interest rates.

What to Watch this Week – Powell Tap Dance

Following last week’s policy meeting, Fed Chair Jerome Powell launched an aggressive PR campaign, supported by a hawkish dot plot showing that most Fed committee members support another 50 basis points of rate hikes this year. However, just a day later, markets had barely priced even one 25-bp hike in July – but no more.

The Fed Chair’s PR skills are lacking. In recent weeks, the Fed Chair has appeared in two different guises: Following the Fed meeting back on May 2-3, a more dovish Powell said that wages don’t drive inflation, suggested that rates are likely already “sufficiently restrictive,” and didn’t dissuade market predictions of rate cuts this year. Fast forward to last week, and we got an entirely different Fed Chair. Powell stated that rate reductions are probably “a couple years out” and that inflation has yet to respond to the 500 basis points of rate hikes since the Fed started its hiking campaign in March 2022.

In his congressional testimony this coming Wednesday and Thursday, the Fed Chair will have another chance to persuade markets that he is supportive of more rate hikes, but it will be a tougher sell now after the Fed’s decision last week to pause hikes. Despite the fact that most on the Fed’s rate-setting committee now expect no recession this year along with higher than desired inflation, the Fed’s action to hold steady on interest rates last week shows either that 1) the Fed is less confident about the economy’s resiliency or 2) are more tolerant of higher inflation.  With this seeming inconsistency, should one follow the age-old mantra: Actions speak louder than words? We think so.

If the economy continues to grow (i.e. avoids a recession) in 2023 and inflation stays as high as the Fed expects, then the Fed would be completely justified in hiking rates by at least 50 basis points more. Thus, we’re on the lookout for stronger than expected economic data in the coming weeks, which, if it appears, will shift the outlook once again to one that includes more hikes than the financial markets currently expect.

Will that better-than-expected economic data show up though? It’s not looking like it. High-frequency indicators show that the economy is still growing below trend, may already be in a recession, and an increase in jobless claims suggests that things may be about to get significantly worse. Here’s a few things to think about:

  1. The jobs market continues to be the foundation of the current expansion; the economy added 339k jobs in May; nevertheless, the recent increase in unemployment claims is concerning. Initial jobless claims increased by 29k to 262k for the week ending June 3 and stayed there for the week ending June 10. While it’s not a trend, that’s much higher than the pre-pandemic average of 218k from 2019.
  2. The housing market is still exhibiting symptoms of instability despite a tentative bottoming in the spring. As borrowing costs decreased, mortgage applications for purchases have increased for the first time since early May. Given the Fed’s seeming propensity for more rate hikes, the rate on a 30-year fixed rate mortgage will probably rise in the future. This dynamic worsens housing affordability and keeps consumers wary as they anticipate a recession.
  3. Consumers may find vacationing much less affordable this summer since airfares are predicted to be significantly more expensive. Given that consumer spending on services will be essential to maintaining the economic expansion, it’s a worrying indicator.
  4. The economy’s manufacturing sector is still weak. It’s difficult to imagine manufacturing returning to expansion anytime soon given that customers are transferring their spending from goods to services.
  5. In response to declining prices and increasing costs, the energy sector has likewise been reducing production. According to Baker Hughes Co., the number of oil rigs increased by just one last week after declining for five consecutive weeks. As a result, spending on privately owned non-residential structures like gas and oil wells will be slashed.

Bottom line? The Fed rate hikes are starting to bite the economy. Are two or more rate hikes necessary as the Fed would like us to believe? Based on recent data, probably not.

Strategy Corner – Construction Loan

Situation: You’re presented with a term sheet for a $50MM,  3-year construction loan where the lender requires the borrower purchase a 1-month term SOFR interest rate cap for the full $50MM loan amount, struck at 4.50%.

Even though the lender is requiring that the rate cap be for $50mm in concert with the loan, the first year of the loan has an “accreting” draw schedule of $4,166,667 per month.

View: There’s a thought that the rate cap may cost less if its $50MM notional is synced with the draw schedule. When rates and volatility were at all-time lows before the pandemic, structuring the cap in that way often didn’t yield any cost benefit to the borrower.

Times have changed. Given the inversion of the SOFR forward curve, such a structure yields great cost benefit to the borrower. For example, for an accrual period running from 7-1-23 to 8-1-23, 1M SOFR is expected to be 5.20%.  For a 3-year loan, the inverted forward curve implies that 1M SOFR will reset at 2.97% for the final accrual period from 6-1-26 to 7-1-26.

This dynamic implies that, by buying a rate cap with a $50MM notional as the lender is requring, the borrower is severely over-hedged and will pay through the nose for the rate cap.

Strategy: Structure the cap with an accreting notional schedule that syncs with the draw schedule, saving the borrower singnificantly on the cost of the rate cap in the process.

In our experience, involving an advisor to assist in your hedging decision is a critical component to a favorable outcome for both lender and borrower. By working in tandem with the lender – and providing analysis to justify the hedge structure – the advisor ensures that both parties, lender and borrower, end up in the best risk and cost position possible.

Real world analysis, with data to back it up provided by the advisor, is just what the underwriter wants. The underwriter isn’t going to do the analysis for you. Let our team’s extensive capital markets experience provide solutions for your particular hedging needs.

Whether or not this strategy works for your specific situation requires some analysis. Curious? Reach out to us: us@derivativelogic.com or 415-510-2100.

Current Select Interest Rates:

Rate Cap & Swap Pricing:

Forward Curves:

10-year US Treasury Yield:

Source for all: Bloomberg Professional