Higher for Longer Begins to Crack

What You Missed

The jobs report for February presented a mixed picture of the state of the labor market, with an unexpected increase in the unemployment rate mixing with a strong headline nonfarm payroll print (+275k). Other data on jobs indicated the labor market is cooling as evidenced by the continued decline in job openings and a decrease in the number of individuals quitting their jobs.  While a weaker jobs market is just what the Fed needs to give it confidence that interest rate cuts are warranted soon, the billion-dollar question now is if the other side of the Fed’s mandate – inflation – is also cooperating to the Fed’s liking. While that remains to be seen, Fed Chair Jerome Powell advised Congress that rate cuts are expected to occur at some point this year; we expect the first to come in June.

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 as Rate Cut Stars Begin to Align

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Following a somewhat mixed jobs report on Friday, interest rates extended their fall amid conflicting economic crosscurrents, settling well below their year-to-date highs. Swaps markets continue to price the first rate cut in June, and a total of four, 0.25% cuts before year end. Inflation data in the coming week will serve as a key check on whether inflation pressures are dissipating fast enough to meet that timeline. In addition, markets are anticipating the Fed’s upcoming revision to their dot plot, or quarterly rate forecasts, which will be made public following the conclusion of the Fed’s March 20th meeting.

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 one basis point 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 twelve basis points week-over-week, to 4.07%, reflecting the view that the jobs market is weakening, inflation pressures are dissipating and that the stars are slowly but surely aligning for a June interest rate cut.

How much higher will SOFR rise? 1-month SOFR, via the SOFR forward curve, implies that one-month SOFR has 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 3.38% in June 2027.

Where is the 10-year Treasury yield headed? The 10-year Treasury yield forward curve implies that the yield will bottom out at 3.98% in January 2025 – it’s sitting at 4.07% 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 levels last seen in late January. Rate cap costs continue to hover 25-30% below their peaks, and will likely continue on their downward path as the likelihood of the first Fed rate hike gets closer. Curious what a rate cap costs? Check out our rate cap calculator.

Elsewhere, equities gained additional ground as investors anticipated easier monetary policy toward the middle of the year. The price of a barrel of West Texas Intermediate crude oil fell $1.36 from this time last week to $77.75, as the US dollar weakened and Gold strengthened.

Mixed Data Implies a Weaker Jobs Market. Is it Enough to Push the Fed Closer to Rate Cuts?

Compared to a downwardly revised 229k gain in January, headline nonfarm payrolls – historically the single most impactful set of data on interest rates –  increased by 275k in February, exceeding the consensus estimate of 200k. The prior two months of jobs data was revised lower by 275k.

In stark contrast to the strength in the headline number, the household survey was weak. Employment fell for a third consecutive month (-184k in February vs. -31k in January). When adjusted to match the definition of nonfarm payrolls, the household survey shows an ever-larger decline, at -271k (vs. -450k prior). Ever wonder why there are two different jobs surveys (headline versus household)? Here’s your answer.

Elsewhere, the unemployment rate (U-3) increased from 3.66% to 3.86%, roughly 0.2 percentage points more than the 3.7% consensus estimate. Average hourly earnings, aka consumer’s wages – a critical metric as it implies their ability to spend – increased by 0.1% month over month (compared to a downwardly revised 0.5% prior), below consensus expectations for a 0.2% increase.

Sounds halfway decent, right? Perhaps not. Almost every jobs report over the last year has been revised lower after the fact, partially due to a persistently low response rate to the  BLS’s surveys used to compile the data. The situation has clouded the jobs’ outlook for a while now, forcing many of us in markets to question the numbers when they’re initially released. It’s no different this time around. Preliminary survey results for February’s jobs report showed a response rate of just 67%; that’s better than January’s 56% but still well below the 72% average for 2017–2022. Considering this, and the significant downward revisions of the jobs data over previous months, we suggest being cautious when interpreting the strong headline print.

Our take: Following January ‘s blowout print, the headline nonfarm payrolls print for February was equally impressive, or was it? Hiring was strong in just a few industries, and more significantly, there was an unexpected spike in the unemployment rate. That spike is in line with signals from other job indicators, such as the household employment survey, which paint a more somber picture of the labor market. In the upcoming months, the nonfarm-payroll data should increasingly reflect that view.

Will the Fed see it the same way? Probably, as the Fed has been more reactive than usual to data surprises lately, as seen in Chair Powell’s swift pivot toward rate cuts in December following a slight weakening in the labor market at the time. We anticipate that nonfarm-payroll prints will continue to decline throughout the spring, paving the way for a rate cut in June.

Powell’s Congressional Testimony Leaned Toward Cuts

We listened to every word of The Fed Chair’s testimony to Congress last week – twice – so you don’t have to. Here’s what it told us.

Powell opened with, “The Federal Reserve remains squarely focused on our dual mandate to promote maximum employment and stable prices for the American people,”.  He continued by outlining the committee’s accomplishments in fighting inflation over the past year. Compare that with his opener this time last year, “My colleagues and I are acutely aware that high inflation is causing significant hardship, and we are strongly committed to returning inflation to our 2 percent goal.”

The drastic difference between the two statements tells us that the Fed’s priorities have changed. It seems the Fed is now paying more attention to the employment component of their dual mandate, which implies that it may quickly move to cut interest rates if the jobs market begins to exhibit more obvious signs of weakness.

As an aside, many of our commercial real estate clients have complained about the methodology the Bureau of Labor Statistics (BLS) uses in measuring housing rents, stating that it falsely shows rents being far higher than they are in reality due to a long lag before real-time rents show up in inflation data. The Fed uses this data in its interest rate decisions, and many have said that the high rent readings have caused the Fed to incorrectly keep interest rates higher for longer than they should be. While that may indeed be true, no one was complaining when the same lag also falsely showed rents being abnormally low a couple of years back, causing the Fed to keep rates lower for longer than they should have been. Something to keep in mind. The bottom line is that it’s unlikely that the BLS will change its methodology just for one industry, and that we’ll all have to get comfortable with it.

Chair Powell addressed the issue in last week’s testimony, stating that the Fed is “well aware” of the issue, which is why the Fed believes housing rents will come down this year, relieving some inflation pressures in the process.

Bottom line? It’s clear to us that the Fed wants to cut interest rates as soon as the data lets them. Chair Powell walked the tightrope during this testimony, sounding just aggressive enough to imply that the Fed will keep rates high if inflation pressures persist, but also implied that the Fed stands ready to cut rates at the first, consistent, credible signal that the jobs market is experiencing a sustained decline. Given our expectation of a weaker jobs market in the coming months, we suspect the door will be open to the first rate cut in June.

What to Watch: Inflation Data to Squash Near-Term Rate Cut Hopes

Now that we’ve assessed the state of the jobs market, focus shifts to the Fed’s other mandate: fighting inflation.

Financial conditions have eased significantly since the Fed pivoted mentally toward rate cuts back in December: The S&P 500 recently hit all-time highs, credit spreads have tightened, IPO and M&A activity has increased. Due to the combination of high cash flows for fixed income owners and record-high stock, home, and Bitcoin prices, consumer spending is currently experiencing a surge.

The problem is, the dynamic doesn’t bode well for inflation’s fall toward the Fed’s 2% target, as a renewed surge in inflation pressures could arise if the Fed cuts interest rates too soon. The Fed is aware of the risk, knows the “last mile” of its inflation battle will be difficult, and is thus taking its time in executing the first rate cut.

February’s Consumer Price Index (CPI) report (Tues.) won’t provide the reassurance Chair Powell needs to speed the Fed’s move toward the first rate cut. Seasonal trends observed in the January report, which drove up core CPI, are expected to have persisted in February, and will likely smother hope for any rate cut prior to June. We’re expecting headline and core CPI to come in at 3.1% and 3.7%, respectively, and for CPI inflation to rise to 0.4% versus the prior month, up from the 0.3% gain in January, while core inflation will likely slow. If CPI comes in below those levels, expect 5 and 10-year Treasury yields to dip below 4% sustainably and for June to be fully priced for the first rate cut. Layer in wages still advancing at a 4.3% pace in the past year, and you’ve got yourself a “no landing” economic scenario.

Elsewhere, with the recent jump in the unemployment rate, anecdotes from soft surveys (National Federation of Independent Businesses, NFIB, Tuesday; Empire State Manufacturing Survey and Univ of Michigan consumer sentiment survey, both Friday) are showing tentative signs of weakness. Hard data, such as retail sales (Thursday) and industrial production (Friday), should also signal a downshift in activity. Meanwhile, the US Treasury’s bond sales will also influence investor sentiment, scheduled to sell a combined $61 billion in 10- and 30-year debt through auctions on Tuesday and Wednesday.

Finally, there are no speaking engagements by Fed officials scheduled this week, as the Fed goes dark in advance of its monetary policy meeting on March 20th.

All told, it’s a scenario that doesn’t require any shift is the Fed’s “wait and see” approach to rate cuts.

Strategy Corner: Accreting Interest Rate Caps

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 loan amount is the notional required for the interest rate cap, and many lenders have traditionally required a borrower to purchase an expensive interest rate cap with a notional amount equal to the fully committed loan amount. Times are changing.  We recently priced an amortizing cap, and the cost was 50% less expensive than a rate cap whose notional amount was equal to the fully drawn loan amount. We asked this lender, “Why the change after so many years?” Their answer? “To be more competitive”.

Are you in the midst of negotiating a construction loan that requires an interest rate hedge? Know your options. Contact us at 415-510-2100 or us@derivativelogic.com to learn what may be available to you.

To learn more, give us a call or schedule a Derivatives 101 session.

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