July Hike is a Done Deal. What’s Next?
What You Missed
The week’s jobs data left economists and market watchers reeling. Last Thursday’s ADP employment report for June (+497k) was so strong that it prompted experts to second guess their forecasts for the future health of the jobs market, and by extension, the Fed’s appetite for higher interest rates. The release of the always-important non-farm jobs report on Friday cleared everything up, however, showing that fewer jobs were created in June (+209k) than anticipated. Through the fog created by conflicting economic data and contrasting themes, the overall view remains clear: The Fed will need to cool demand for labor to sustainably rein in inflation, and to accomplish that, they’ll need to hike interest rates at least one more time and keep rates higher for longer.
Running the Numbers: Short-term Rates Near their Cycle Peaks
Bond investors got limited relief from the June employment data, as robust wage growth helped two- and five-year Treasury yields reach their highest levels since 2007 and sent 10- and 30-year Treasury yields to their highest levels of the year.
For the week, the 2, 5, 10 and 30-year Treasury yields rose a respective 1, 16, 23 and 21 basis points, to 4.94%, 4.34%, 4.08% and 4.08%. Pressure persisted in the 2s-10s Treasury yield spread, a widely watched barometer of recession potential, to trade at -87 basis points, backing off extreme inversion near -108 seen last week. Swaps traders are pricing in a quarter-point rate hike on July 26, and about 45% odds of another one by year end. Swap markets still predict a rate cut by the end of this year, reflecting the seeming resilience of the US economy, but one that falls into a mild recession in Q4 2023. It’s all part of an emerging theme of deeply diminished expectations that the Fed’s 500 basis points of cumulative rate hikes are poised to set off a sharp recession, rather, expectations persist that we’ll eventually get a recession, but one that arrives later and ends up being shallower than previously thought.
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 5.30%. 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 3 basis points point week over week, to 4.85%, 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 near 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 to peak in the fall, at 5.42%, 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, spiked to levels last seen in May. Elsewhere, equities were lower in the week amid the sharp rise in longer-term bond yields. The price of a barrel of West Texas Intermediate crude oil rose $2.65 to $73.07, while the US Dollar and gold both traded flat.
Hiring Slowdown Won’t Deter the Fed from Hiking Again on July 26th
In what is always the single most influential piece of economic data on interest rates, America’s job creation engine produced just 209k new non-farm jobs in June – below the consensus forecast of 230k. Hiring was most robust in education and health services (+73k), construction (+23k), professional and business services (+21k) and leisure and hospitality (+21k).
Payrolls in the private sector only increased by 149k in June (the consensus was for 200k), and the previous month’s numbers were revised down by 24k. The household survey of employment – as opposed to the headline data that’s produced by surveying businesses – showed a 273k increase in total employment as workers entering the labor force found jobs at nearly three times the rate of those entering the labor force who were previously unemployed.
A total of 133k people entered the labor force, keeping the labor force participation rate stable at 62.6%. The result was a slight drop in the unemployment rate from 3.7% to 3.6%. Average hourly earnings (aka wages) increased 0.4% month on month in June. The May wage figures were revised up to show 0.4% month-on-month wage growth.
Our take: Despite the underperformance in job creation last month, hiring remains too robust for the Fed’s liking. When combined with the uptick in wages, and their propensity to keep consumers spending and inflation high, the Fed has all the ammunition it needs to justify a 25-basis point rate hike on July 26th. However, since the Fed has signaled its intent to slow its pace of rate hikes and given our expectation that the economy will more convincingly toward year-end, the Fed’s appetite to hike again after this month will steadily evaporate.
Markets Continue Backing Away from Expectations of Near-Term Rate Cuts
Investors continue to steadily shift away from expectations of drastic, near-term Fed rate cuts toward a scenario where rates stay higher for longer. Risks for the Fed Funds rate remain skewed to the upside as inflation risks remain elevated, financial conditions remain accommodating despite the Fed’s rapid interest rate hikes, and job growth continues to outpace population growth.
Our take: The billion-dollar question now is how much further the Fed will need to hike the Fed Funds rate beyond its 5.25-5.50% range, with a 25-basis-point hike already baked in for July. We’re still expecting a more notable economic slowdown later this year, even though the economy exhibits a bit more momentum at mid-year than anticipated. Sooner or later, the economy will lose steam due to the accumulating headwinds of tighter lending standards, shrinking household cash buffers, and more pronounced job-market weakness.
Short-term Yields are at Their Highest Since 2007 – How Much Higher Will They Go?
The less-then-inspiring June jobs report and robust wage growth helped send two- and five-year Treasury yields to their highest levels since 2007 and 10- and 30-year Treasury yields to their highest levels of the year, in anticipation of additional Fed rate hikes.
Now that the banking crisis appears to be over, financial conditions have relaxed again, and Treasury yields have recouped a sizeable portion of the recession premium they first priced in. They’re now closing in on levels where they should be trading based on prior relationships with interest rates.
The change is further evidenced in the rapid ascent in stock prices. Even though Fed Chair Powell recently stated that the central bank hasn’t ruled out consecutive rate hikes, the Nasdaq 100 Index is up a staggering 40% so far this year. All told, the heavy selling in front-end Treasuries that has sent rates soaring since the end of 2020 probably has some more room to run.
Our take: The mix of slowing growth and cooling inflation in the second half of the year should keep yields from rising much further. However, don’t get too excited: A still-tight jobs market should also keep yields from declining materially. If our expectations of a notably slower economy near year’s end and a Fed that stops hiking after this month prove to be dead wrong though, two-year yields will continue to rise on the back of a resilient jobs market and looser financial conditions. Higher short-terms yields equate to more expensive interest rate caps, and a persistently inverted yield curve will extend the appeal of borrowing fixed over floating.
What to Watch: Inflation Data to Seal the Deal on a July Rate Hike
The release of Consumer Price Index (CPI) data for June (Wed.) will take the spotlight this week and will be the last major data release the Fed can opine on before its blackout period begins ahead of the July 26th policy meeting. As is widely known, the Fed has already telegraphed its intention to hike rates by another 25 basis points at the meeting, thus the market’s attention is focused on the shifting balance of risks, and how that will affect the Fed going forward.
Although we anticipate a drop in annual headline CPI inflation to ~3.1%, much of the recent decline can be attributed to base effects in energy prices, which the Fed will probably look beyond. Core inflation – what the Fed is really focused on – has proven far more persistent than the headline number, and we expect a 0.3% increase there. Core services inflation will likely stay too high for the Fed’s comfort even as core goods prices decline. Rents – one of the largest components of CPI and one of the main reasons CPI inflation remains stubbornly high – will likely continue to show a slow descent from peak levels, though it remains too high for the Fed.
The job market’s role in sustaining core inflation has been highlighted by Fed Chair Powell routinely, and the June jobs report showing 209k jobs added and growing wages supports Powell’s view that for inflation to dissipate sustainably, the demand for labor must be curtailed. Annual declines in producer-price growth (Thurs.) and import-price growth (Fri.), while helpful in cooling overall inflation, won’t sway the Fed’s focus away from the jobs market.
Credit conditions and financial system liquidity, which fall outside of the Fed’s dual mandate, are becoming more important considerations in Fed decision-making. According to the minutes from the June FOMC meeting, released last week, delaying that month’s rate hike was mostly due to concern regarding the extent of impending credit tightening. The soundness of the banking system, as reported at the firm level, will help guide Fed policy judgments as Q2 bank earnings begin on July 14th.
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