Jobs Data Will Crush Hopes for Fed Pivot

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Yields across the maturity spectrum leaped higher for the fourth consecutive week, as financial markets continued to cave to the Fed’s view that inflation is enduring, requiring more rate hikes. A benign combination of receding inflation readings and moderating US economic growth in January have now given way in February to troubling inflation reports and signs that the economy isn’t slowing quickly enough to send the Fed to the rate-hiking sidelines any time soon.

Investors have now priced in a higher peak for how high rates will go, as well as scaled back their bets on any rate cuts by year’s end. Interest rate futures now project that the Fed Funds rate – that’s the rate the Fed raises of lowers as it affects interest rate policy – will peak at 5.45% (it’s 4.75% now) in September, implying that we’ll see at least another 50-basis points in hikes before the Fed has completed its hiking cycle. This change brings the market outlook closer to the Fed’s own December estimates, and is how future rate moves will likely play out.

For the week, the 2, 5 and 10 Treasury yields rose a respective 8, 8 and 4 basis points. Of note was the 10-year Treasury yield rise above 4% mid-week, a level that hasn’t been seen since November 2022. The jump in short-term yields held the 2s-10s yield curve, a widely watched barometer of looming recession, -0.91%, its most inverted level in 42 years. Overall, the continued jump in yields, an about-face from their falling trend over the last few months, reflects a new awareness from financial markets that the Fed is serious, while still expecting rate cuts before the end of the year.

Elsewhere, equities were slightly firmer in the week despite a continued rise in yields. The price of a barrel of West Texas Intermediate crude oil rose $3.25 to $77.50, as the US Dollar weakened, and Gold strengthened.

Hedging Costs Hold Steady

3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, rose to a fresh all-time high of 4.94%. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘24), a rough estimate of where markets expect 3-month Term SOFR will be a year from now, rose 36 basis points from this time last week, to 5.55%, in line for where markets expect the Fed Funds rate will peak (5.40%).

The SOFR futures market, a widely observed signal for how SOFR will behave in the coming months, implies that 3-month SOFR will now peak in the fall near 5.67%, 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 interest rate caps, maintained its accelerating trend, raising rate cap prices in the process. Despite the rise in volatility, it remains far lower than the peaks we saw back in the last half of 2022. We still expect rate volatility to continue to moderate over the long term, and rate cap costs continue to fall, with some bumps higher in between, as the end of the Fed’s rate hiking campaign inches closer.

Curious about where interest rates are headed for the rest of the year? Check out our Interest Rate Outlook

Borrowers Beware: The LIBOR to SOFR Transition Is Not Your Friend

We’re being flooded with calls and emails from borrowers 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.

Confused or uncertain about how the transition will impact you? Give us a call, 415 510-2100, to help guide you through it with as little damage to your bottom line as possible.

Evidence of Entrenched inflation is Piling Up

Although no major data on the state of inflation were released last week, most second-tier economic data indicated that inflation is on the rise. The “prices paid” component of the Institute for Supply Management’s manufacturing purchasing managers index – a gauge of wholesale prices from more than 300 manufacturing firms – leaped from 44.5 in December to 51.3 in February. Elsewhere, an increase in unit labor costs of 3.2% in the Q4 2022 was another cause for concern.

Our take: The prices-paid portion of the manufacturing index marks the first time it has been in expansionary territory (above 50) since September and was much higher than what was expected (46.5). This means that demand at the wholesale level is softening at a slower pace as businesses continue to try to manage inventory, hoping they won’t be stuck with excess goods if demand cools in the coming months.

Consumer Demand Remains Resilient – for Now

Consumer demand – which drives about 75% of all US economic activity – remained strong in February, according to the ISM Services survey, a barometer on the overall economy by showing the economic trends in the service sector. The tone of the data was cautiously upbeat, with demand remaining strong enough for firms to keep hiring. Increases persisted across all sectors, with 13 service sectors reporting growth. Wholesale trade, transportation and warehousing, information, and management of companies and support services were the four industries reporting a decline.

Our take: The data plays well into the theme that demand for services remains strong, applying continued, upward pressure on hiring and inflation, and by extension, pressures the Fed to keep up its inflation fight by hiking interest rates further and keeping rates high for longer. Despite the data, we wonder just how long pent-up demand for services can continue and suspect that consumer demand will peak by the summer, giving the Fed reason to pause (see below).

Consumer’s Confidence in the Future May Have Peaked

The consumer confidence index – a measure of how optimistic or pessimistic consumers are regarding their expected financial situation – fell again in February. As such, consumer demand for goods and services is expected to fall in the coming months, as implied by readings of future business conditions, job availability, and incomes. Adding to the coming pain are households’ evaporating savings buffer, their growing reliance on credit and rising in credit-delinquency rates, which, in total, don’t bode well for a bright economic future and imply that we’ll be economic recession within a year.

ApartmentList.com reported that rents have decreased each of the previous six months and are currently 3.5% less than they were in August. The decrease comes after a two-year, 25% surge in rents. The Wall Street Journal reported that in 2023, close to 500,000 more units are anticipated to come online, potentially further pressuring prices lower. US mortgage rates have increased by roughly 1% since their January lows and are now back above 7%, which may dash hopes that the worst of the housing market slump is behind us.

What to Watch – Jobs Data to Validate Market’s View of Higher Rates

The focal point of the week ahead – the state of the jobs market – is always the most impactful on interest rates than any other flavor of economic data. Nonfarm payrolls (Friday), ADP’s National Employment Report, and JOLTS (both Wednesday) are three crucial jobs-market gauges for February that will provide insight into whether the blow-out strength seen in January was just a fluke or the start of a strengthening trend. Although we anticipate another positive reading of the state of the jobs market for February, we doubt the positive reports accurately reflect the jobs market downturn that has probably already begun.

It has become more difficult to get a clear picture of where the economy is and where it is headed because of the quality of recent data. The JOLTS survey’s (a gauge that gives a more complete picture of the U.S. labor market than by looking solely at the unemployment rate) response rate has decreased to around 30%, and its results have started to become volatile. Using information from additional job postings in addition to the official poll, it seems that job openings are finally declining. According to the February ISM Services survey (referenced above), hiring new employees is becoming easier for businesses. Helping to make the case that the jobs market is beginning to cool exists via more reliable data like from the Employment Cost Index, which implies that supply and demand for labor are now more evenly balanced.

Historically, most high-profile layoffs –  most recently from the likes of Google, Microsoft, Twitter, Disney, Citi, 3M, and Goldman Sachs to name a few – usually don’t show up in the jobs data until a couple of months later. If that timing holds true this time around, we expect to see initial jobless claims climb in March. Unfortunately for the Fed, the March jobs reports – which will likely show signals that the jobs market is weakening –  won’t be released until after the next Fed policy meeting on March 22nd. Regrettably, the Fed can’t wait for the haze to clear before making choices about interest rate policy. Heading into its March meeting, Fed officials will have in hand two strong jobs reports and two strong inflation reports.

A peak Fed Funds rate of 5.45% has now been fully priced by financial markets, which is likely higher than what the average member of the Fed’s rate-setting committee is expecting. Yet, Fed officials probably prefer the current market stance to the market’s positioning just one month ago, when markets were expecting a sharp policy reversal toward cutting interest rates. Congressional testimony by Fed Chair Jerome Powell on Tuesday and Wednesday will validate the market’s current stance.

Strategy Corner

Concerned about where term rates will be when your loan matures 6-months, one-year or two-years from now?  With the long-term future direction of rates murky, you should be. Lucky for you, there are ways, using derivatives, to reduce the uncertainy around what rate you’ll pay when you refinance, and ultimately, protect yourself against higher term interest rates over the long-haul.

For a sneak peak into real world results from such a strategy, check out this recent article in the Wall Street Journal (warning, paywall): Chicago Property Developer Scores With Audacious Interest-Rate Bet – WSJ

Structuring a hedge to mitigate future term rate exposure involves careful planning and expert advice.  We’ve been discussing this type of strategy for literally years: Swaptions: What Smart Borrowers Are Doing Now – Derivative Logic . Call us to discuss your future funding concerns and for help with planning and executing a strategy that’s custom designed just for you.

Mitigating interest rate risk is dynamic and not static. The complacency of believing rates would stay low forever caught both borrowers and lenders off guard. Now that the paradigm of low rates forever has changed, both borrowers and lenders look for ways to ease the pain that higher interest bring to the table. Interest rate derivatives can provide some with the perfect solution, but it comes at a cost. Another strategy chosen by some is to do nothing. Doing nothing is definitely a strategy, but doesn’t mean borrowing floating or fixed and forget it.

Derivative Logic prides itself in education and structuring hedges that make sense. There are times when we suggest doing nothing, but we provide the analysis of how we came to that conclusion. Our focus isn’t based on earning transaction fees but on doing the right thing.  Just ask our clients. Give us a call (415-510-2100) for a complimentary review of your capital structure. We might say your capital structure doesn’t require our services yet.  Let us emphasize YET.

Current Select Interest Rates:

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Source for all: Bloomberg Professional

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