Markets Slowly Cave to the Fed
What You Missed
While commentary from Fed officials in the past week sent the army of those hoping for any near-term Fed rate cut even further into retreat, annual adjustments to inflation data and a Fed survey suggesting banks expect to tighten credit further for a variety of loans kept the rate cut dream alive.
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Running the Numbers: Rates Flat in a Quiet Week
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Finally, bond traders are taking to heart one of the most classic maxims in financial markets: Don’t Fight the Fed.
Let’s review some history briefly. Investors repeatedly miscalculated how high the Fed would hike interest rates back in 2022-2023, handing them big losses in 2022 when Treasury bond prices fell steeply. In hindsight, it turned out to be the Fed’s steepest interest-rate hike cycle in decades. Fast forward to early last year, when bond traders also incorrectly predicted that a banking crisis would compel the Fed to stop hiking rates. Wrong again. More recently, they bet that Fed Chair Powell would quickly shift to cutting rates back in December after he indicated he was done hiking for good, with the first rate cut perhaps occurring as early as March, despite the Fed’s projections to the contrary. Wrong yet again.
As of late however, it seems traders are starting to listen. The futures markets have begun pricing in the possibility that the Fed will only cut interest rates four times this year in 0.25% increments, slightly more than the three quarter-point cuts projected by the Fed via their Summary of Economic Projections. That represents a significant change from the end of the previous year, when futures traders were betting on seven cuts this year, believing the Fed would lower interest rates by a full percentage point more than it was hinting at the time.
Although the Fed could also be very wrong about its future plans for interest rates, as was the case back in 2021 before all the rate hikes, investors are now less likely to be taken by surprise. Following three brutal years in the bond market, this change is expected to bring some stability to the financial markets.
For the week:
Where will SOFR be a year from now? 3-month (CME) Term SOFR, a more useful gauge of hedging costs than 1-month Term SOFR, held steady at 5.31%. 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 two basis points week-over-week, to 3.89%, reflecting a market in stasis amid a week of little economic data or market-moving events.
How much higher will SOFR rise? 1-month SOFR, via the SOFR forward curve, implies that one-month SOFR has peaked near 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 3.47% in June 2026.
When will rate cap costs decline? Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, fell once again week over week. Lower rate volatility is helping keep rate cap costs down 25-30% across the board from their peaks. Curious what a rate cap costs? Check out our rate cap calculator.
Elsewhere, equities rose to record highs. The price of a barrel of West Texas Intermediate crude oil rose $3.85 from this time last week to $76.67, as the US dollar and Gold both weakened slightly.
Fed Rate-Cut Hope Suppression Parade in Full Force
Fed speakers were out in force last week, doing all they could to squash any lingering dreams of a March rate cut. The consensus message was that the Fed’s rate-setting committee members are looking for more evidence that the decline in inflation pressures is “durable” and that it will ultimately align with the Fed’s 2% target before they move to cut interest rates, though that step will likely occur “later this year.”
For some context to the comments, the core personal consumption expenditures price index (PCE), which excludes volatile food and energy components and is the Fed’s preferred inflation measure, increased by 2.9% year over year in December. Over a six-month period, its annualized pace is just 1.9%, reflecting the Fed’s progress in its inflation fight.
Trading in futures markets implies that investors believe the Fed will begin cutting rates by June at the latest. While we agree with that, we’re sticking to our prediction that the first rate cut will occur in May.
Of particular note in Fed commentary last week was confirmation that the Fed is watching the deterioration of private credit closely – that’s all you debt funds and non-bank bridge lenders out there – given its tremendous growth over the last decade and the fact that the Fed doesn’t have a direct “line of sight” into it. We’ll see if more regulation is headed toward that sector of credit, as it’s never good if the Fed is “watching closely”.
Consumer Price Index Revisions Keep the Falling Inflation Narrative Alive
Around this time every year, the Bureau of Labor Statistics – who compiles all the data on inflation – revises the seasonal factors it uses in its Consumer Price Index (CPI) calculations for the past five years by incorporating price movements from last year.
Confused yet? Don’t worry. Just know that the revisions confirm that inflation pressures have indeed subsided over the past year, and more importantly, show a quicker decline than previously thought in prices for “core” services, the category the Fed worries most about.
Why you should care: As a direct result of last week’s revisions, the core PCE Deflator – the Fed’s preferred gauge of inflation, should now show an even quicker dissipation of inflation pressures than originally thought. So, too, will supercore PCE – Fed Chair Jerome Powell’s personal favorite inflation gauge. Taken together, these revisions and their impacts will give the Fed greater confidence that the end of the road of its inflation fight is coming into view and that it can continue mentally moving toward rate cuts. We’re still expecting the Fed’s first rate cut to come in May, but last week’s CPI revisions will spur some to continue to call for a March rate cut.
Fewer Banks are Tightening Lending Standards
The quarterly Senior Loan Officer Opinion Survey (SLOOS), showed that while fewer banks are tightening business lending standards, they expect to continue raising standards for unsecured loans and those secured by flimsy assets, specifically for commercial real estate (CRE) and certain types of consumer loans.
To be specific, the survey showed that the net share of banks reporting tighter lending conditions for commercial and industrial (C&I) loans kept declining. In a similar vein, fewer and fewer banks are raising loan rate spreads over their cost of funds. Although it isn’t as widespread now as it was in the previous SLOOS survey from last October, demand for commercial loans is still declining.
Looking ahead to the rest of 2024, the SLOOS survey showed that banks anticipate tightening lending rules even more for consumer loans such as credit cards and auto loans, as well as for commercial real estate.
Large US banks are well positioned to take market share from smaller banks in commercial real estate loans (CRE). Smaller banks have always had a larger exposure to CRE than their larger counterparts, making up roughly 30% of their assets compared to just 7% for large banks. Further, small banks’ exposure to CRE has been rising versus their overall asset base. The SLOOS data does not split up responses for large and small banks for CRE, but they do for commercial and industrial loans (C&I). C&I loans are a conservative benchmark for all types of bank lending, as their standards tend to be more stringent because the loans are often unsecured.
Bottom line: While that’s no surprise to anyone, it’s likely that the Fed had the results of the January SLOOS survey in hand during its last rate-setting meeting on January 31st, and the fact that the survey suggests that banks are inching toward an increased appetite for lending probably gave the Fed an impetus to state that it’s in no hurry to cut rates anytime soon.
What to Watch: Signs of Falling Inflation to Bring First Rate Cut Closer
The disinflation story for 2023 remained mostly unchanged despite the annual changes to CPI data released last week. The adjustments seem anticlimactic at first glance, especially in light of the excessive attention Fed officials paid to them before their release on February 9. Nevertheless, while they were mostly ignored by financial markets, it’s probably a mistake to dismiss them outright as they confirm the disinflation narrative that has been around for awhile, especially in core services, and most notably in housing rents. If you’re having trouble with the details, just know that the CPI revisions will boost the Fed’s confidence that it is making real progress in its inflation fight, and that inflation will soon come in very close to its 2% target, which by extension, will pave the road toward rate cuts.
The Fed will get two more sets of inflation data before its next rate -setting meeting on March 20th, and this Tuesday’s release of January’s Consumer Price Index (CPI) will likely confirm inflation’s softening trend seen the last few months. Taken together with Friday’s release of the Producer Price Index (PPI), which is also expected to confirm inflation’s declining trend, we’ll have even more of the ingredients needed to seal the deal on a May 0.25% Fed rate cut.
Other data releases in the coming days will provide insights into consumer health and the jobs market. Retail sales (Thursday) will likely confirm suppressed spending in January and a downward revision to the “buy everything shiny” reading from December. Improved consumer sentiment will persist though (Univ of Michigan Consumer Sentiment Index, Friday) sustaining our hopes for a bright future. Finally, a cornucopia of business surveys (National Federation of Independent Businesses, Tuesday; Empire State Manufacturing Survey, Thursday.; Philadelphia Fed Index, Thursday) will probably show that current hiring conditions are weak, although there’s optimism about the future.
Bottom line: As it contemplates the timing and degree of its first rate cut, the Fed is actively weighing the dangers of another inflation spike or a more severe contraction of the jobs market against the data on hand, which show inflation rapidly headed toward its 2% target. Its choice will be further influenced by data on tap in the coming week, but in the end, it won’t offer a foregone conclusion.
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?