Higher for Longer Rates are Coming for You
What You Missed
The ongoing theme for interest rates continues to be one of cautious optimism. The Fed and markets want to believe that the threat of high inflation is behind us but worry that more rate hikes might be necessary to slay the inflation dragon once and for all. Amid mixed economic signals and the uncertainty of future rate hikes, America’s resilient economic performance thus far is slowly but surely bringing almost everyone around to the conclusion that rate cuts won’t happen anytime soon, and that the Fed’s 5.00%+ in rate hikes will continue to show their negative impact in the economy.
Although most of the US economic data reported last week surprised in a good way, as is usually the case, the devil was in the details. Bargain hunters splurging on Amazon’s Prime Day helped to support consumer spending in July, while unexpectedly strong production in America’s factories last month can be chalked up to abnormally warm weather. As a result, it’s no surprise that the Fed has struck a cautiously optimistic tone and is hesitant to imply that there’s another rate hike locked and loaded for its next meeting in September.
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Running the Numbers: Rates Higher Across the Maturity Spectrum
For the week:
2-year Treasury yield: up 1 basis point to 4.98%
5-year Treasury yield: up 8 basis points to 4.43%
10-year Treasury yield: up 13 basis points to 4.32%
30-year Treasury yield: up 16 basis points to 4.28%, a 12-year high
1-month Term SOFR: flat at 5.31%
3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, rose just one basis point to 5.37%. The implied yield on the 3-month SOFR futures contract 1-year forward (September ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, rose two basis points point week over week, to 4.57%, reflecting the mixed bag of inflation data and view by some in markets that the Fed has nearly finished its hiking cycle.
The SOFR futures market, and the forward curve it projects to the world, implies that 3-month SOFR is already near its peak, and forecasts that it will peak in the fall, at 5.41% (unchanged from last week), then decline consistently over the next year as the Fed eventually cuts interest rates in Q2 2024.
Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, finished the week at about where it started. Elsewhere, equities were undermined by surging bond yields – especially real, inflation-adjusted yields – along with uncertainty surrounding China’s property and shadow banking sectors. A barrel of West Texas Intermediate crude oil fell $0.62 to $81.89.
Retail Sales Prove Unexpectedly Strong, But It Likely Won’t Last
The spending appetite of the US consumer – who alone is responsible for roughly 70% of all US economic activity – proved surprisingly strong last month. Headline retail sales surged 0.7% in July, vs. an upwardly revised 0.3% in the month prior. That was much stronger than the consensus estimates of 0.4%. Sales in the control group, which don’t include things like cars, gas, food services, and building supplies but are crucial in estimating economic growth (GDP) increased by an even greater 1.0% (up from 0.5% previously). Spending on the more interest rate-sensitive goods seems to have stalled; autos and furniture declined, and spending on building supplies has shown considerable volatility.
Online sales increased in the month following Amazon Prime Day as lower-income households stocked up on necessities and back-to-school supplies. Spending on food services, the main indicator of service spending (versus spending on goods), indicated that consumers’ desire for entertainment this summer remained strong, particularly among affluent households. All told, the retail sales data bode well for hopes of solid spending momentum for Q3 – a critical ingredient to avoid a recession.
Our take: Although US consumers continued to spend in July, we don’t believe it will last for very long. We suspect that the bottom half of the population’s surplus funds are nearly exhausted, and households are under greater financial strain because of higher interest rates, a dynamic that will increasingly show its face into the fall. Adding to the looming woes, gas prices surged toward the end of July, leaving lower-income households more stretched financially. Retail sales data are notoriously volatile; we’re avoiding reading too much into their strength. Bottom line? Despite the strong retail sales headline number, the Fed will see through it, using the wobbly underlying spending picture to justify a pause in its rate hiking campaign at its September 20th policy meeting.
Fed Meeting Minutes Imply Rates Will Stay Higher for Longer
Last week, the Fed released the minutes from its policy meeting in July. The takeaway? Reasons for a September pause are multiplying.
According to the Fed’s July meeting minutes, the voting committee members were guardedly hopeful about ensuring a soft economic landing for America’s economy. However, “most” members still fear that inflation pressures could rise anew, implying that interest rates will stay higher for longer with rate cuts not happening until we’re well into 2024. Further, the minutes showed a contingent of the voting committee expressing worries that the risks to GDP and inflation are becoming more and more symmetrical, meaning they could go either way, indicating that recent bond market bets that the Fed’s rate-hiking cycle is over are probably correct.
Bottom line? The minutes reveal that while the Fed maintained a positive forecast for economic growth, it exercised caution to avoid adopting a policy position that would be seen as overly aggressive. We expect the Fed to retain some optionality by pausing at its September meeting and maintaining a higher-for-longer posture as growth and inflation pressures slow.
Industrial Production Also Showed Surprising Strength – Or Did It?
In July, overall industrial production increased 1.0%, exceeding the consensus prediction of 0.3% growth. It was helped by the output of the electric utilities, as the demand for power increased due to the unusually warm July. Although manufacturing output remained weak, it increased by 0.5% as automakers made up for the low car inventories brought on by the post-Covid chip shortage.
Our take: The upward surprise in July’s output figures was driven more by weather than by demand for goods and was almost entirely offset by downward revisions to the prior month’s data, which significantly diminishes the report’s positive impact. All told, that tells us that America’s manufacturing sector will likely continue slowing as consumer demand for goods stalls.
What to Watch – All Eyes on Chair Powell in Jackson Hole
This Friday, Fed Chair Jerome Powell will address the annual Jackson Hole conference of central bankers against a very different economic backdrop than last year’s gathering. Then, it became obvious that he needed to adopt a consistently aggressive tone when inflation rose past 8%. Since then, the Fed has hiked rate by 3%, the jobs market is showing more obvious signs of cooling, credit conditions have tightened with more likely to come, and other major economies, such as China and Germany, have struggled.
Thus, we predict that Powell will adopt a more measured stance this time around, while highlighting the necessity to maintain high interest rates for longer but also teasing us that the end of rate hikes in this cycle is near. Powell likely sees the current level of “high” interest rates increasingly making their presence known in the economy through the rest of 2023 and well into 2024 via higher unemployment, less robust consumer spending and cooling inflation pressures.
The fly in your summer rose’? Markets have been defying that view over recent weeks, as evidenced recently by longer-dated Treasury yields’ rise to multi-year highs (e.g., the 30-year Treasury yield rose to a 16-year high, 4.39%, last week) on the back of mixed inflation signals. If long-term Treasury yields stay near where they are now, mortgage rates will rise in concert, potentially sparking a correction in the housing market (existing home sales on Tuesday; new home sales on Wednesday).
While the good economic news seems to have dominated the headlines of late, we suspect that a recession is still certainly possible before the end of the year. The rise in long term yields is steepening the Treasury yield curve (long-term yields higher, short-term yields stable or falling), adynamic that usually happens after a curve inversion and right before a recession shows up.
Are “High” Interest Rates Here to Stay?
A client called last week inquiring about our thoughts on the level of the 5-year Treasury yield. He and his equity partner were figuring out when to rate lock (you know who you are). The partner was wanting to hold off locking now, believing that the 5-year Treasury yield was “too high” and would soon come down significantly.
The partner is probably wrong. Here’s why:
- The US economy’s surprising resiliency, the nation’s soaring debt and deficits, and growing worries that the Fed will maintain high interest rates are pushing yields on the longest-dated Treasuries to their highest levels in more than a decade.
- While the 5-year Treasury isn’t really considered to be in the “long-term” bucket, as the longest term Treasury yields, e.g., the 10-year or 30-year, rise and stay there, it adds upward momentum to short-term yields like the 5-year.
- While higher long-term yields soften the economic blow to bond holders via higher coupons, they also pose a threat to consumer spending, home sales, and the values of soaring tech companies.
- Additionally, higher long-term yields raise the Federal government’s financing costs, making deficits even worse. The US Treasury is set to borrow $1 trillion this quarter to close the current gap. More bonds on offer by the Treasury further drives their yields even higher.
- What dynamic could come to the rescue and help yields fall? An economic recession. But based on the economy’s current performance, a recession showing up any time soon is questionable, and even if we find ourselves one, it’s likely to be relatively short and shallow.
Strategy Corner: Interest Rate Swaps
We’ve been having an increasing number of conversations with clients who are contemplating borrowing at a floating rate from a bank and fixing that floating rate via an interest rate swap. These conversations are emanating from a myriad of industry verticals: public corporations, Native American Tribes, municipalities, non-profits, and the higher end of commercial real estate.
The prevailing theme? The borrower’s self-acknowledged lack of understanding of interest rate swaps and the need for a trusted, third-party advisor to assist them in navigating the uncertainty.
Here’s a handful of common borrower assumptions we hear all the time that are dead wrong and will ultimately cost the borrower money if not corrected:
- “My bank is giving me a competitive rate.”
- “I don’t understand swaps. My bank is educating me and looking out for my interests.”
- “The bank is betting against me.”
- “Swaps are the same as gambling.”
- “Derivatives are risky.”
While we won’t bore you here with rebutting each of the above, you can find detailed explanations here:
Still have questions? Contemplating a swap? Contact Us – Derivative Logic