Markets Slowly Caving To The Fed

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What You Missed

Yields across the maturity spectrum jumped higher, as financial markets showed their first signs of caving to the Fed’s incessant “interest rates are going higher and staying there longer” drumbeat. Consumer sentiment and jobless claims data both demonstrated the economy’s resiliency, supporting Fed Chair Jerome Powell’s assessment that the battle against inflation is still far from over.

For the week, the 2, 5, 10 and 30-year Treasury yields rose a respective 4, 9, 9, and 14 basis points. Of specific note was a jump in the 2-year Treasury yield, which leapt 10 basis points from its mid-week lows  to 4.52%, a level last seen in late November, as markets priced in more Fed hikes. The jump in short-term yields pushed the 2s-10s yield curve, a widely watched barometer of the liklihood of a recession, on Thursday to -0.86%, its most inverted level in 42 years. Overall, the 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, global equities were slightly lower on the week as rising yields offered investors an alternative to stocks. The price of a barrel of West Texas Intermediate crude oil added $1 to trade at $78.50, as the US Dollar and Gold both weakened.

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, continued its steady ascent, rising five basis points in the week to 4.76%, another all-time high. 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 16 basis points from this time last week, to 4.67%.

The SOFR futures market implies that 3-month SOFR will now peak in the fall – as opposed to its previous prediction of late spring –  near 5.42% 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 rate caps and other option-linked interest rate hedges, bucked its recent declining trend, jumping higher to levels last seen in late January. 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.

Are you attending the MBA’s CREF 2023 conference in San Diego on February 12-15th?  We are. Reach out to arrange a meeting with Jim Griffin @ 310-283-6779 jgriffin@derivativelogic.com or Carol Ng @ 801-580-0873 cng@derivativelogic.com.

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.

We won’t bore you with the intricacies here, but know that many borrowers, without outside advice, end up with higher interest expense because of the conversion from LIBOR to SOFR. This is a real issue that if not handled properly, could result in negative economic consequences for the borrower.

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.

Parade of Fed Officials Showed Fed’s Resolve to Keep Hiking

The economic outlook was discussed publicly by several Fed officials last week; their comments coalesced into consensus that the central bank still has work to do before it can declare victory in the fight against inflation. Chair Jerome Powell warned that if the tight jobs market conditions persist, a higher peak in the Fed’s Fed Funds rate may be required, and that the Fed faces a “tough road ahead” in attempting to tame inflation without tanking the economy in the process. In direct response, financial markets became less tone deaf to the Fed Chair’s commets, finally adjusting their trajectory of interest rates, pricing in an additional 0.25% rate hike this year while pushing out rate cuts to the fall from the summer.

Our take: Its seems that financial markets are finally starting to listen to the Fed, as evidenced by the shift in rate expectations, to a scenario where the Fed hikes more and cuts later than previously expected. We expect the shift to continue.

Households Showed Resilience Amid Still-high Inflation

The University of Michigan’s preliminary sentiment index for February improved to 66.4 from January’s 64.9, above the consensus expectation of 65.0. Households were more optimistic in the planned purchases for large household goods (e.g. washers and dryers, refrigerators) and for homes, but not for cars. The average 30-year mortgage rate is now 6.12%, down from 7.2% in October, while mortgage applications increased by 18% for the week ending February 3rd when compared to their late-October 2022 low. The January gangbuster jobs report, which showed payrolls adding more than twice as many jobs as were expected, gave the sentiment index a boost. Except for the tech industry, there have been very few layoffs thus far this year, with the unemployment rate falling to 3.4% in January, its lowest level since 1969.

Our take: Given that consumer purchases account for 70% of all US economic activity, it’s critical to pay attention to consumer sentiment to gain a sense of where the economy is headed, and for clues into how much more and how high the Fed will hike interest rates. The data tells us that while households are still resilient despite stubbornly high inflation, that resilience is at significant risk of decline as inflation weighs on purchasing power and erodes living standards, not to mention ballooning worries that unemployment may increase later this year. However, consumers’ improving sentiment, which adds to similar improvements seen in January and December, means that a recession isn’t imminent.

Soft Landing Narratives Become More Common – Are they Wrong?

After January’s stellar jobs data, market narratives have become generally more upbeat about the likelihood of a soft economic landing, but the most-loved economic models still indicate a very high risk of recession in the coming 12 months. Recession probability increased in January according to commonly used yield-curve models, which use the spreads between 2-year and 10-year, 3-month and 10-year, and 3-month and 18-month forward Treasury yields as their sole input. According to the most recent assessments, the probability of a recession increased to 66% (from 62% in December), 76% (from 63%), and 77% (from 51%), respectively, since all those yield curves continued to invert in January. Fed Chair Powell’s preferred model, which monitors 3-month versus 18-month-forward Treasury yields, interestingly displayed its worst decline in January. A year ago, that model saw almost 0% probability of recession. Curious to learn more about yield curve inversion and what it means? Check out our article, “Yield Curve Inversion: What it Really Means for Borrowers”.

Our take:  Take the model results with a grain of salt. Every recession is unique, therefore estimating probabilities based on prior recessions may miss special circumstances as the economy emerges from a rare pandemic that usually occurs only once every century. Because of this, we also focus on high-frequency indicators like mortgage applications, restaurant bookings and spending on travel and entertainment. In opposition to the doom and gloom implied by the yield curve models, high-frequency economic indicators are conveying signals that are more positive. Although we continue to anticipate at least a mild recession beginning in Q3 2023, a recession isn’t necessarily a foregone conclusion. If a recession shows up, and it would be a miracle if one doesn’t given how quickly the Fed has hiked interest rates, its depth and length will ultimately be determined by the Fed.

 What to Watch – Latest Inflation Gauge to Determine if Market Repricing Sticks

The market has started to reassess the Fed’s rate path; it now expects that policymakers will raise rates to a peak of 5.20% before cutting them by around 25 basis points before the end of this year. This repricing may continue in the upcoming week. A strong inflation print could act as the catalyst.

The January reading of the Consumer Price Index (Wednesday) may show what Fed Chair Powell has said numerous times, but the markets have chosen to ignore: inflation’s decline is just getting started, and the process of getting it down to where the Fed wants it will be rocky.

Any reacceleration in the CPI will likely be more than simply a speed bump in inflation’s decline. We suspect that CPI’s falling three-month trend will be blunted by January’s higher reading, driven there by higher gasoline prices, slower declines in the prices of goods and rising prices for services. This should support the recent shift in market predictions that the Fed will need to hike rates to a higher peak than thought previously.

Elsewhere, other data releases in the coming days may demonstrate that rising economic activity is causing prices to increase anew. The housing (housing starts, Thurs. ) and manufacturing sectors (Industrial Production, Wednesday), which have both shown weakness in recent months, appear to have stabilized. Retail sales (also Wednesday) will most likely reflect stable household spending, powered by strong auto sales.

A solid showing of data would imply that a recession isn’t imminent, as consumers typically postpone buying durable goods like cars if they feel their financial futures are imperiled. Our presumption is that a recession will start toward the end of the third quarter.

Observations and Announcements

Why do borrowers continue to borrow floating and not fixed? Call us to discuss the pros and cons.

Lenders and borrowers are buying deep-in-the-money caps to hedge floating rate loans – but why? Look out for an upcoming DL report discussing the reasons with supporting analysis.

Call us to discuss some of the issues and unique solutions of having to extend rate caps with below market strikes and how borrowers can best manage higher replacement rate cap escrows.

Current Select Interest Rates:

Rate Cap & Swap Pricing:

Forward Curves:

10-year Treasury Yield:

Source for all: Bloomberg Professional

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