Jobs Data to Power Soft Landing Hopes
What You Missed
Central bank moves were front and center last week, with the Fed and European Central Bank both hiking interest rates by 25 basis points, and the Bank of Japan startling markets with a de facto hike in longer-term interest rates. Optimism for a US soft landing intensified as core inflation decreased, even as consumer spending remained resilient. Markets now believe the Fed won’t feel the need to hike interest rates again this year. Focus now shifts to when the Fed will cut interest rates, and what economic environment must exist for it to do so.
Running the Numbers: Short-term Rates Still Near their Cycle Peaks
For the week, the 2-year Treasury yield fell 4 basis points to 4.89%, as the 5, 10 and 30-year Treasury yields rose a respective 5, 9, and 10 basis points, to 4.19%, 3.96%, and 4.02%.
3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, rose 3 basis points to 5.36%. 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 five basis points point week over week, to 4.83%, reflecting the accumulation of less than encouraging economic data that implies short-term rates will go higher in the near-term, but that they’re very close to their peak.
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% (remember, it’s 5.32% right now), then decline consistently over the next year as the Fed eventually eases.
Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, finished the week about where it started, now sitting at levels last seen in a month ago. Elsewhere, equities were modestly firmer on the week after a flurry of central bank meetings and data showing inflation is cooling. The price of a barrel of West Texas Intermediate crude oil rose $5.25 to $81.19 amid signs of solid US economic growth, while the US Dollar and gold mostly treaded water.
Fed Implies It’s Standing Pat in September
The Fed’s 25 basis-point hike to a 5.50% upper-bound Fed Funds rate was widely anticipated. The lack of substantive changes to the official policy statement suggests that most Fed officials still want to keep the door open for another rate hike this year, hoping to see more sustained evidence of that inflation is truly on the retreat, before more clearly signaling a pause. But Chair Jerome Powell’s performance at the post-meeting press conference told us that he’s willing to skip a hike at the upcoming September meeting if inflation data remain weak in the meantime.
Outside of interest rates, last week’s meeting revealed that the Fed no longer expects a recession, but they do foresee a “notable” slowdown in the economy later this year. According to the minutes of the prior Fed meeting, in June, Fed staff estimated a somewhat higher probability of recession than not. With data since then surprising to the upside, it’s hardly surprising that Fed officials would make the shift in their recession outlook.
Our take: The Fed wants to leave the door open for future hikes if data warrants them – although the bar to hike in September will be high.
What’s inflation – the real driver of what the Fed does going forward – expected to do over the next few months? Before the September 19-20 FOMC meeting, there will be two more Consumer Price Index (CPI) and job reports. We expect that data on job openings and hiring, which are due on August 1 and 4, respectively, will show clearer evidence of job-market weakness. We also expect core inflation numbers to be as low as the June CPI report. Furthermore, the resumption of student-loan payments in October will put consumer spending to the test.
Last week’s Fed meeting solidified our expectation that the Fed will keep rates steady for the rest of 2023, and finally move toward cutting rates in Q2 2024. Swaps markets now expect rate cuts as soon as March of next year. Nonetheless, there are numerous potential adverse supply shocks on the horizon that could reverse the recent softening of inflation pressures, and the housing market could also reaccelerate. Key dangers include widespread labor strikes and a global food-price shock caused by weather. If those shocks come to fruition, inflation pressures may reignite by the second half of 2024, leading the Fed to resume hiking.
Are Calls for No Recession Overdone?
Fears of a recession are fading as confidence about a soft landing for America’s economy has taken hold of the narrative. There are several reasons for the improved outlook, the most compelling of which is that the Biden administration’s industrial policies are encouraging more private investment than predicted. Because of positive optimism in economic surveys, combined with solid signals that inflation is truly on the retreat, it’s probably the right call to believe that a recession, if one shows up at all, will show up later than previously expected.
However, there are signs that optimism about a soft economic landing is overblown, and that a recession will show up before the end of the year. Past recessions have shown that soft-landing optimism was widespread even when the economy is on the verge of a recession. Of note:
- In October 2007, two months before the National Bureau of Economic Research (NBER) dated the official start of a recession, the Fed was opining on broad positive surprises in economic data and the resilience of the American economy. The prevailing economic story at the time was one of a soft landing.
- The NBER’s official declaration of a recession usually comes after one has already begun. Only in retrospect, once any data corrections have been completed, can they undoubtedly identify a recession, thus it’s certainly feasible that a year or two from now, the NBER will declare that a recession began last year.
- The NBER’s primary recession indicators are currently glowing yellow. Two of the six monthly indices used by the NBER to track recession risks are off their peaks, another two haven’t worsened in the last six months. The fifth, nonfarm payrolls, the bright light of the bunch, are likely to be revised lower soon. The sixth, real Personal Consumption Expenditures, a measure of consumer’s spending on goods and services, has slowed meaningfully in Q2. Looking ahead, consumer spending could face strong headwinds for the rest of the year as student loan repayments resume, credit becomes less available, and savings dwindle.
- Finally, GDP and GDI growth (click here to learn what they are and how they differ from one another) are also used by the NBER to date recessions. Their combined average was a paltry -0.4% in Q4 2022 and a very modest 0.1% in Q1 2023. Definitely not confidence inspiring.
All told, recent positive data surprises certainly demand a rethink of recession forecasts. Nonetheless, the data as a isn’t strong enough to convince us just yet that a recession late this year or early next is off the table.
What to Watch: More Support for the Soft-Landing Narrative
Two months before the start of the recession in December 2007, the consensus was that the economy would experience a soft landing from the housing bubble; a belief evidenced by markets and the Fed at that time. Except for the Senior Loan Officer Opinion Survey (the latest version was released today), most economic data had surprised to the upside, and the housing market had stabilized.
A recession showed up nonetheless. Will it be different this time? Perhaps, as recent economic data have shifted back in favor of the soft-landing scenario. Activity data have consistently surprised to the upside of late, while inflation data for June were soft. This week’s jobs data (nonfarm payrolls, Friday; JOLTS, Tuesday) should show robust hiring by companies, while surveys will show business and consumer activity picking up (manufacturing, Tuesday; services, Thursday).
We’re not expecting a soft landing, which, by the way, the Fed has accomplished just once in the last 50 years. The recent softening in inflation pressures doesn’t imply an unusual break in the relationship between strong demand and rising prices, rather, it’s a sign of real cracks in the economy. Said another way, the latest wave of soft inflation is being driven by a downdraft in demand, even after supply chains have now largely recovered from their COVID induced stupor.
Unit labor costs for the second quarter (Thursday) are expected to be close to the Fed’s 2% inflation objective. This will be mostly owing to a comeback in labor productivity a modest increase in aggregate hours worked, which is typically an early indicator of a weakening labor market. That’s one reason we believe the price data’s significant disinflation signal is suggesting a fracture in underlying demand that isn’t yet visible in real-time activity data.
I Got a Call: BSBY versus SOFR and Interest Rate Swaps
A borrower client called last week about wanting to fix a floating rate loan indexed to BSBY (Bloomberg Short-Term Yield Index) with a pay-fixed interest rate swap. The BSBY index is highly correlated to LIBOR because it is a credit sensitive rate based upon bank credit spreads. The market favors SOFR indexed swaps. Without getting too deep in the weeds, it makes more sense to convert the index in the swap from BSBY to SOFR. Like converting a LIBOR indexed loan to SOFR, that means that a SOFR conversion spread is added to the rate. Let’s assume the conversion spread is 0.12% and the credit spread on the loan is 2.25%. The adjusted credit spread is increased to 2.37%, indexed to SOFR. To fix the loan, the borrower executes a pay fixed interest rate swap indexed to SOFR.
Attempting to do this on your own isn’t as simple as it seems and why you should contact an advisor with capital markets expertise. What SOFR index will be used? Term SOFR, Simple SOFR, or Compounded SOFR? Another factor to keep in mind is the swap spread over mid-market. What is a fair spread – 15, 20, or 30 basis points? There are many variables that banks use to determine swap spreads (their profit on the swap), but only an objective derivative advisor can provide insight and analysis to quantify the spread and negotiate it lower if needed.
In the case of interest rate swaps, the lending bank is trying to sell you something, and it’s your job to understand it thoroughly. Do you? Trust us when we tell you, the bank isn’t acting as your fiduciary.
Call the experts, that’s us, with capital market experience needed to help you mitigate interest rate risk and achieve the outcome you desire.