When will the cost of rate caps come down? In our recent travels across the country, we’ve seen keen interest in an answer to this question. It’s been top-of-mind during the lunch-and-learn sessions we’ve conducted coast-to-coast over the last several months. The answer? In time. We need more information from the Fed, as well as economic data, to determine how consumers and employers are reacting to higher interest rates and prices. By the end of the summer, the Fed will have met two more times – June and July – and we will have received 3 months of data taken during this time of rapidly rising interest rates and inflation.  With this economic and policy information,  the markets should have a clearer picture of the Fed’s thinking about how high they’ll hike interest rates.

This ”clarity” will eventually translate to a flatter and lower SOFR forward curve, which will also directly translate to lower costs for rate caps generally. Until then, watch rate volatility, which will have more near-term impact on rate cap costs. The higher the rate volatility, the higher the cost of a rate cap, and vice-versa. Where’s rate volatility been and where’s it going you ask? Look no further than our favorite gauge of rate volatility, the ICE Bank of America MOVE index. It’s a useful tool for measuring bond market sentiment via a forward-looking measure of bond market risk and is something we watch intently.

Markets backed off steep rate hike expectations. Investors are expecting the Fed to raise rates less dramatically in the coming year than they were a few weeks ago. Markets now expect the Fed to hike the federal funds target rate to just under 3% (it’s 1% now), down from nearly 3.5% little over a week ago. Weakening US economic data, such as a precipitous drop in new home sales and softer purchasing managers’ and regional Fed surveys, sparked the change in mindset. On Thursday, the first-quarter GDP estimate was lowered to an annualized -1.5% from a previous estimate of -1.3%. The core personal consumption expenditures (PCE) price index, the Fed’s preferred inflation indicator, fell to 4.9% year over year in April from 5.2% in March, according to data released last Friday.

Our take: Markets are slowly coming around to what we’ve been saying for weeks now: there is no way the Fed will live up to the seven rate hikes markets expect of them by year end. Why? While the Fed will most likely push forward with a 0.50% hike at its next meeting on June 15^th, followed by another 0.50% hike this summer, and a 0.25% hike in September, it will mostly likely take a pause thereafter as economic growth stumbles, inflation moderates, and mid-term elections loom.  In the meantime, watch gasoline prices, threats of drought, and the Russia-Ukraine war for signals on inflation’s future path and the Fed’s possible reaction to it.

CBO expects slower growth, lower inflation. Both inflation and growth are expected to slow later this year and into 2023, according to the US Congressional Budget Office (CBO). The CBO forecasts a 3.1% growth rate in 2022, down from 5.5% in 2021, and a 2.2% growth rate the following year. According to the CBO, inflation will decline to 4.7% in late 2022 (its over 8% now) and 2.7% in 2023, while unemployment will remain at 50-year lows. The government’s budget deficit is forecast to fall to roughly $1 trillion this year, down from $2.8 trillion in fiscal 2021, due to reduced federal pandemic funding.

Our take: While the accuracy of the CBO’s predictions historically is questionable, financial markets pay attention to them nonetheless, as we saw in last week’s downward moves in yields. Ignore the CBO at your peril.

Signals of slowing economic momentum multiplied. In recent months, it seems the residential property market in the US has lost a lot of steam. According to the most recent data, the pace of new house sales dropped sharply in April, falling 16.6%, the largest dip since 2013, even while prices continued to rise, with the median price up 19.6% from a year ago. According to Realtor.com, the supply of existing homes continues to rise. As sellers strive to take advantage of increasing prices, the number of listings increased by 9% compared to the same period a year ago. As an aside, for a peek into banks’ appetite for lending to businesses and households, check out the Fed’s Senior Loan Officer Opinion Survey on Bank Lending Practices. It showed no easing in lending appetite in whole through April, and is something to keep an eye on.

Elsewhere, as the summer driving season begins, seasonal demand for gasoline in the United States is at its lowest level since 2013 (save for 2020), according to Bloomberg. Prices are around 50% higher than a year earlier, and demand is about 5% lower.

Finally, retail sales advanced 0.9% in April, slightly weaker than the consensus estimate of 1.0%, but did so based on factors that don’t really inspire confidence. American consumers continued to spend aggressively, depending mainly on credit cards in the face of rising costs, weakening sentiment, and falling real wages.

All told, the data sets and other signals of slowing growth tell us that we’ll see a sharp slowdown in economic growth this year, somewhere around 2%, down from last year’s red-hot 5.5%. Spending by the always-important US consumer – as opposed to businesses – will continue to provide the bulk of any growth momentum.