March Rate Cut a Toss Up
What You Missed
Retail sales, industrial production, and housing starts – aka “hard” economic data for December – all surprised to the upside last week, but regional Fed surveys’ “soft” gauges revealed a different, more negative economic picture. Financial markets sharply reduced their bets on Fed rate cuts after seeing the hard data, but comments by Fed officials, ahead of the next policy meeting on January 31st, implied that the Fed is taking its cues from the soft data. We continue to expect the Fed to embark on its first rate cut in May.
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Running the Numbers: Rates Higher as March Cut Conviction Collapses
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Most Treasury yields hit their highest points of the year last Friday, as positive economic data deflated the belief that the Fed will start cutting interest rates in March. Short maturity yields (e.g., the 2-year Treasury), which are most susceptible to shifts in monetary policy, ended the week at their highest closing levels so far this year. Longer-dated yields retreated after briefly hitting year-to-date highs.
For the week:
2-year Treasury yield: up 11 basis points to 4.23%
5-year Treasury yield: up 8 basis points to 4.01%
10-year Treasury yield: up 2 basis points to 4.08%
30-year Treasury yield: down 1 basis point to 4.29%
1-month Term SOFR: up a half of a basis point to 5.34% (SOFR won’t move markedly lower until we’re closer to a Fed cut, as it reflects the market’s forecast for rates 30 days out).
Where will SOFR be a year from now? Switching over to 3-month (CME) Term SOFR, a more accurate gauge of hedging costs than 1-month Term SOFR, rose two basis points to 5.32%. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘25), an estimate of where markets expect 3-month Term SOFR to be a year from now, rose 21 basis points week-over-week, to 3.66%, reflecting the collapse of near-term rate cuts bets, and forecasting a rising cost to hedge interest rate risk.
How much higher will SOFR rise? 1-month SOFR, via the SOFR forward curve, implies that one-month SOFR has peaked at 5.33%, and will decline precipitously over the next year as the Fed eventually cuts interest rates several times throughout 2024. The forward curve projects that 1-month Term SOFR will steadily decline from here on out, eventually bottoming out near 3.34% in December 2025. That forecasted bottom in 1-month Term SOFR rose 26 basis points week-over-week.
When will rate cap costs decline? Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, fell week over week. While rate volatility moved lower, it’s still high historically, keeping rate cap costs high. Curious what a rate cap costs? Check out our rate cap calculator.
Elsewhere, equities were slightly lower on the week as markets unwound aggressive rate cut bets. The price of a barrel of West Texas Intermediate crude rose $1.19 to $73.59. The US dollar and Gold both weakened.
Retail Sales Data Give the Fed Zero Reasons to Cut Rates in March
December saw a rise in both in-person and online consumer spending as businesses offered deals to clear out year-end inventory. Despite rising interest rates from the Federal Reserve and a cooling labor market, consumer spending – which alone counts for over 70% of all US economic activity – was strong in sectors that traditionally reflect consumer fundamentals. This implies that consumers have yet to rein in their spending, giving the Fed little reason to cut interest rates anytime soon.
Diving in, headline retail sales increased 0.6% in December compared to a 0.3% increase in November, handily exceeding expectations of a 0.4% increase. Excluding cars and gasoline, retail sales rose 0.6% (vs. 0.6% prior), above expectations (0.3%). Control-group retail sales – which exclude vehicles, gas, food services, and building materials – rose 0.8%, also handily beating the 0.2% consensus estimate.
The billion-dollar question now is how long such robust spending can go on amid high interest rates, a weakening jobs market, ballooning household debt and a seemingly ever-eroding geopolitical landscape.
Bottom line? The strong retail sales showing in December tells us that consumers were still drawn to deals and discounts during the holidays. Combined with the fact that consumption doesn’t always decline during a downturn, the strong data doesn’t make us any less cautious about a weakening US economic outlook mid to late this year, with at least a few Fed rate cuts in tow to combat it.
Fed’s Beige Book Still Showing Businesses Pinning their Fates on Near-term Rate Cuts
As we stated in our newsletters late last year, recessionary dynamics likely began last fall, and we anticipated that the Fed would begin talking about rate cuts at its December meeting, which, in hindsight, proved true. The Fed was motivated to address rate cuts given the dramatic decline in its Beige Book a few weeks earlier, which showed two-thirds of federal districts reporting flat to declining economic activity through mid-November.
The January Beige Book indicated little to no shift in economic activity from December’s, which was broadly viewed as downbeat. Most Fed districts surveyed in the Beige Book stated that their economic prospects had either improved slightly since December or had positive expectations for future growth. This is in line with an improving outlook by businesses on the hope that the Fed will soon begin cutting interest rates. As January’s Beige Book reported, “Numerous contacts in various sectors” expressed optimism about the possibility of lower interest rates. What will happen to this positive business sentiment if the Fed cuts later and less than is hoped for?
Fed Pivot Partygoers Are Suffering from a Hangover
(We told you so) Last week’s message from Fed Governor Christopher Waller and Atlanta Fed President Raphael Bostic stating that rate cuts won’t be rushed, combined with robust, “hard” economic data led financial markets to interpret the week’s events as implying that rate cuts won’t come as soon as previously expected.
The shift in sentiment was clear: market bets on a March rate cut dropped precipitously, from 80% odds at the start of last week to just 41% now, placing a march cut in the realm of a coin toss. Markets also scaled back their expectations of the number of Fed rate cuts this year, down from 6.5 quarter-point cuts expected at the start of last week, to just 5.5 now. We expect further moderation in the financial market’s expectations over the coming months and are banking on three to four quarter point cuts, with the upper-bound of the Fed Funds rate falling to around 4.5% by year’s end (it’s 5.5% now), on the back of a gradually slowing jobs market, a slow and steady fall in inflation coupled with a surprisingly resilient but nonetheless slowing economy.
What to Watch: Fed’s Favorite Inflation Gauge Set to Keep the Rate Cut Hype Alive
The main catalyst for the tectonic shift in market sentiment toward later and fewer rate cuts – comments from Fed officials – will be absent this week as the Fed goes dark ahead of its January 31st policy meeting.
The latest round of inflation gauges will take center stage instead. The muted core PCE inflation print from December (Friday) will take the spotlight; we expect that the one-, three-, and six-month annualized measures of inflation will all fall below the Fed’s 2% target. While that’s undoubtedly good news, there is still a significant obstacle to the Fed falling headlong into rate cuts: changes to CPI seasonal factors on February 13 may reverse the PCE deflator’s progress toward disinflation, just as they did the previous year. The state of the surprisingly resilient economy is another obstacle.
Zooming out to the big picture, for good reason, Wall Street has become more optimistic about economic growth going into 2024; examples include the housing market’s recent upturn (new home sales, Thursday; pending home sales, Friday). Thursday’s GDP data for the fourth quarter probably slowed, but it will still fall within the Fed’s predicted range of 1% to 2%.
Given the ongoing, murky mix of positive hard data but weak soft data, we’re confident in sticking to our guns in expecting that rate cuts will come later and in fewer numbers than the markets do, and based on the sea change seen last week, it seems the financial markets are coming around to our view.
To review, “soft data”, e.g., business, consumer confidence and sentiment surveys, financial market variables, and labor statistics, have shown a slow and steady deterioration over the last few months. In contrast, “hard data”, such as data published by government statistical agencies like retail sales, industrial production, and Gross Domestic Product, show no discernible economic decline.
Strategy Corner: Blend and Extend Interest Rate Swap – How to Immediately Reduce Interest Rate Expense
Does extending the maturity date of an interest rate swap make sense? If you have an interest rate swap maturing soon, extending the maturity date can lower the current fixed interest rate without having to terminate the existing swap and paying any breakage cost. Even if the swap has a positive market value, it may be advantageous to extend. Forward interest rate curves are inverted which means term rates are lower than the floating rates. This is because the market expects the Fed to cut interest rates in the future. By extending the maturity date of the swap, the hedger is capturing the curve at the point where short-term rates are lower than current rates. This means that the hedger can reduce the existing pay-fix swap rate by as much as 50 bps or more. Curious? Call us to see if extending your interest rate swap makes sense.
Extending or Replacing Your Rate Cap? A Few Things to Keep in Mind
- In general, rate cap costs are down 25-30% from their peak.
- If your cap is in-the -money, where its strike is below SOFR’s current level, expect your lender to require the same in-the-money strike on the extension/replacement rate cap, regardless of how the asset is performing. Hoping for a much higher/cheaper strike? Good luck with that outside of a formal refinancing of the loan.
- Balance sheet lenders are more flexible in rate cap negotiations, CLO funded lenders, much less so.
- We are routinely seeing lenders allow for the term of the rate cap extension to be much shorter than what is written in the loan agreement, e.g., a 90-day extension versus 1-year, saving the borrower money. Why? Given the broad expectation for lower rates, they’re more comfortable with the rate and price risk. However, in all cases, the borrower will have to continue to roll the cap every 90 days if the loan remains outstanding.
- On a construction to mini-perm bridge loan, make sure to work with the lender to allow for the rate cap’s notional amount to sync with the anticipated draw schedule (an “accreting rate cap”). Why pay for “insurance” you don’t need?