Hope For Fed Pivot Will Soon Pop
What You Missed
Yields across the maturity spectrum were mixed, as the Fed slowed its pace of rate hikes while signaling that there’s more to come. Despite the central bank’s message, bond markets continue to expect rate cuts from the Fed this year, perpetuating the standoff that’s doomed to resolve, perhaps harshly, later this year.
For the week, the 2-year Treasury yield rose five basis points, the 5-year traded flat, the 10-year fell one-basis point, and the 30-year fell four-basis points. Overall, the stagnation in yields, a continuation of their falling trend over the last few months, still reflects the financial market’s belief that the Fed won’t be able to hike rates as much as it claims, and that the US economy won’t be able to handle higher rates for long, eventually tipping into a recession later this year.
Elsewhere, global equities were higher in the week but off their peaks on the markets versus the Fed dynamic. The price of a barrel of West Texas Intermediate crude oil fell about $3 from a week ago to $77.50, as the US Dollar strengthened, and Gold weakened. The US 2-year vs. 10-year Treasury yield spread, a widely watched barometer of the likelihood of a looming recession, dipped once again toward its most inverted level since the early 1980s, to -0.80%.
Hedging Costs Ease Further but Remain High
3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, continued its steady ascent, rising one basis point in the week to 4.69%, an all-time high. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘24), a rough estimate on where rates will be a year from now, rose thirteen-basis points from this time last week, to 4.31%.
The SOFR futures market continues to imply that 3-month SOFR will peak in late spring – along with the Fed Funds rate – near 5.18% followed by a gradual decline over the next three years as the Fed eventually eases. Finally, interest rate volatility, a key driver of the cost of rate caps and other option-linked interest rate hedges, continued its declining trend established in late December 2022, hovering at levels last seen in June 2022. After last week’s Fed downshift to a 25-basis point hike, calmer seas are coming to Treasury yields, as the breakneck pace of Fed rate hikes that roiled yields are sparked huge increases in the cost of rate caps over the last year is now calming. We expect rate volatility to continue to moderate, and rate cap costs continue to fall, as the end of the Fed’s rate hiking campaign inches closer.
Are you attending the MBA’s CREF 2023 conference in San Diego on February 12-15th? We are. Reach out to arrange a meeting with one of our experts.
Borrowers Beware: The LIBOR to SOFR Transition Is Not Your Friend
While at NMHC last week, this topic came up often in our discussion with clients, 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.
We won’t bore you with the intricacies here, but know that many borrowers, without outside advice, end up with higher interest expense because of the conversion from LIBOR to SOFR. This is a real issue that if not handled properly, could result in negative economic consequences for the borrower.
Confused or uncertain about how the transition will impact you? Contact us to help guide you through it with as little damage to your bottom line as possible.
Fed Showed Its Resolve to Keep Hiking
Financial markets rallied on Wednesday and Thursday after the Fed, the European Central Bank and the Bank of England all raised interest rates at their early-February policy meetings. While acknowledging that inflation is mostly on the retreat, Fed Chair Powell hinted at the Fed’s resolve to raise the Fed Funds rate – the rate the Fed raises of lowers at it hikes/cuts – above 5% (it’s 4.75% now). In the post-meeting press conference, where the Fed’s real stance on rates is communicated, Powell repeatedly cited an obscure measure of inflation the Fed is most focused on: the core personal consumption expenditures index (PCE) for services, excluding housing rents, which is showing inflation in this category holding steady at 4% for most of the past year, twice as high as the 2% the Fed wants to see before backing off its rate hiking campaign.
What the heck is core personal consumption expenditures index (PCE) for services, excluding housing rents, anyway? The Fed is concerned that inflation will persist unless growth in wages slows or unemployment increases. Labor makes up the largest share of the cost structure for services, versus in the production of goods, raw materials generally comprise the largest portion of cost. According to the Fed’s logic, rising labor costs are the main driver of cost in delivering these services, and if one looks at the tight jobs market, there’s little sign this measure of inflation will decline enough to satisfy the Fed anytime soon. All told, the Fed could easily hike twice more – a 25 basis point hike on March 22nd followed by another 25 on May 3rd – pushing the Fed Funds rate to 5.25%, just above where markets expect 3-month Term SOFR to peak, at 5.18%.
Hot Jobs Market is Kryptonite to Hopes of a Fed Pivot
The state of the jobs market in January adds to signals that the Fed’s war on inflation isn’t over yet. America’s economy added 517k jobs in January, far exceeding the consensus forecast of +188k. Adding to the gain, the prior two months’ payrolls were revised higher by a net 71k. Highlighting the skew between the supply of labor and demand for it, the job opening-to-unemployed ratio, the Fed’s favorite gauge of tightness in the jobs market, leaped to 1.92; that’s nearly two open jobs for every person that’s unemployed. For perspective, its higher than the 1.74 seen in November, and much higher than the 1.15 seen just before the pandemic in 2019. The surge in job creation saw the unemployment rate fall to a 53-year low of 3.4%. Average hourly earnings, aka wages, rose 4.4% year over year, down from a 4.6% growth rate in December.
Yes, that’s right, growth in wages, which Fed Chair Powell is citing as a key driver of inflation in services, and a big reason why the Fed states it needs to keep hiking rates, fell. So, what gives? While wages are showing signs of decline, an elevated pace of workers quitting their jobs for better, higher paying ones combined with high job openings mean that it’s far from clear that wage growth is slowing toward a level consistent with Fed’s 2% inflation target. As such, the Fed will keep hiking.
Our take: Central Banks 1, Rates Traders 0. Notch one to central banks in the faceoff with traders over the direction of interest rates, with the strong jobs data leaning strongly in favor of rates going higher and staying there longer. Despite still-high inflation, its clear that America’s economy is strong enough to sustain more rate hikes, and the Fed will surely deliver them.
The blowout jobs data is consistent with a record number of job openings in December – eleven million – and falling jobless claims. While wage growth is slowing, it’s unclear whether this slowdown is sufficient to bring wages down to the Fed’s price objective. The jobs market is just too tight to be consistent with sustainably cooling inflation. It’s a combination that gives the Fed all the ammunition it needs to justify continuing down its hiking path, while avoiding a pivot to lower rates anytime soon. Like we’ve said for literally months now, if you want to know what the Fed will do next, watch the jobs market. That same belief still holds true today.
The billion dollar question now? What if inflation stays elevated, rather than come back down the way both the markets and the Fed assume. Working against the “falling inflation” narrative later this year could be still-high core inflation readings, a slowdown-induced corporate earnings recession, higher interest rates, or some combination of all three.
What to Watch – Markets versus the Fed, who’s Correct?
The bewildering financial market rally that ensued after Fed Chair Jerome Powell’s post-meeting press conference, where both stock and bond prices rose (yields fell), tells us that markets are focusing too much on Powell’s seeming lack of conviction on how high rates will go, and saw his weak opposition to loosening financial conditions as validating market bets of near-term rate cuts.
The Fed Chair’s comments, or lack thereof, just emboldened markets in how they were already trading: in utter denial of the Fed’s claims that rate hikes will continue, pushing the Fed Funds rate to 5.25% and hold it there for all of 2023. At the end of the day, everyone knows that the Fed will eventually cut rates. The questions is when, and from what level.
We’ll get more clarity in the data-light week ahead and suspect that upcoming economic indicators will lean toward the Fed’s view. The number of claims for unemployment benefits (Thurs.) will likely continue to point to a tight jobs market, and views of where inflation is headed in the short-term (University of Michigan Consumer Sentiment Index for January, Friday) likely rose anew on the back of higher gasoline and food prices. If so, the Fed’s prediction of stubbornly high inflation may be accurate, and rate cuts are off the table for the foreseeable future.
Look for Fed members out in force to push back agaist the financial market’s soft interpretation of last week’s events. We will also see some politcal noise involving the Chinese surveillance balloon and the President will deliver his State of The Union address on Tuesday.
Interest Rate Swaps: Myths and Misconceptions
We’ve been pulled into many discussions between floating rate borrowers and bank lenders of late, where an interest rate swap is on the table as a possible vehicle for hedging rate risk. Given our decades of experience in trading swaps on the trading floors of large, money center banks, we’re experts at understanding the nuances and complexities of the swaps market. During our countless discussions with clients from a myriad of industries, and financial and non-financial staff, there are certain beliefs about derivatives that we consider myths or misconceptions. Considering a swap to hedge rate risk? Here’s high-level run down of commonly misunderstood aspects that if ignored, will cost you money:
1: “The bank is betting against me.”
2: “When unwinding a swap, the negative termination value isn’t really a loss to the bank.”
3: “The Bank is earning more in interest because I have to write a check every month on the swap.”
4: “The ISDA and Schedule to the Master Agreement are non-negotiable.”
5: “Derivatives are risky.”
6: “Swap rates are transparent; anyone can find them.”
7: “A Pay-Fixed Swap is the best method to hedge floating rate debt.”
8: “My Bank is giving me a competitive rate.”
9: “I’m concerned if I hire an Independent Derivative Advisor, I may lose some negotiating power.”
10: “Why pay an Independent Derivative Advisor when the Bank can offer the same service.”
To learn more about the pros and cons of interest rate swaps, sign-up for our Derivatives 101 seminar. It’s free. Email us email@example.com
Current Select Interest Rates:
Rate Cap & Swap Pricing:
10-year Treasury Yield:
Source for all: Bloomberg Professional
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