Maybe Rates Aren’t High Enough After All

What You Missed

As we knew they would, interest rate markets backed off expectations of any near-term Fed rate cut as a mix of data and events conspired to create the impression that rates would stay higher for longer. Minutes from the Fed’s May 1st policy meeting showed that many Fed officials are open to rate hikes if inflation pressures increase, as the committee acknowledged that new signs of robust economic activity have emerged. All told, we’re sticking to our expectation of just one rate cut at most this year, in December, as many signals paint a picture of a robust US economy taking “high” interest rates in stride.

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Running the Numbers: Rates Higher as Markets Abandon Rate Cut Hopes

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Last week, the US two-year note closed at approximately 4.95%, towards the higher end of this month’s range (4.7% to 5.03%). This reflects a combination of conflicting data and indications from several Fed officials that they are willing to maintain higher interest rates for longer. Some in the Fed even went so far as to express a willingness to hike interest rates to win the inflation battle if necessary. Fortunately for you and I, derivative markets don’t yet see rate hikes as a real possibility, helping to prevent bond yields from surging.

As of now, interest rate swap markets are pricing approximately 32 basis points of Fed rate cuts for the year, implying just one cut for all of 2024. Traders had adjusted their pricing to around 50 basis points of cuts following last week’s release of the April inflation data, which was lower than expected, but they backtracked this week.

For the week:

Where will SOFR be a year from now? 3-month (CME) Term SOFR, a valuable gauge for the true cost of interest rate hedging, rose three basis points to 5.35%. The implied yield on the 3-month SOFR futures contract 1-year forward (June ‘25), an estimate of where markets expect 3-month Term SOFR – and by extension, hedging costs – to be a year from now, rose 11 basis points week-over-week to 4.55%, reflecting the renewed view of markets that the Fed isn’t cutting interest rates anytime soon.

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 in early 2025. The forward curve projects that 1-month Term SOFR will steadily decline from here, eventually bottoming out near 3.71% in August 2028, which is up a few basis points from this time last week.

Where is the 10-year Treasury yield headed? The 10-year Treasury forward yield curve implies the yield will bottom out at 4.36% in October 2025 and then stage a slow and steady sequential rise. Ultimately, Fed Chair Powell’s legacy will be a 10-year Treasury yield just above 4%.

While the forward curves for SOFR and Treasury yields aren’t forecasts – they’ve proven to be a horrible predictor historically – they do give one a peak at the market’s current thinking.

When will rate cap costs decline? Rate volatility, a vital driver of the cost of option-based interest rate hedges like rate caps, continued its downward trend and is approaching a two-month low. Rate cap costs continue to hover 25-30% below their peaks and will likely continue their downward path as the road toward the Fed’s first rate cut gets shorter.

Are you curious about what a rate cap costs? Check out our rate cap calculator. The calculator is a valuable tool for providing an estimate, but if the expected start date is a couple of months away or the cap’s notional amount is amortizing/accreting, give us a call at 415-510-2100 for indicative pricing based upon the specific economics.  Cap costs can vary widely – as much as 40% – when considering changes in the notional schedule or “step-up” strike structures.

Elsewhere, equities were modestly lower on the week amid firmer global bond yields. The price of a barrel of West Texas Intermediate crude oil fell $0.76 from this time last week to $79.07 as the US dollar and Gold both weakened.

Fed Minutes Imply that Rates May Not be High Enough

The Federal Reserve meeting minutes provide details on what the Fed’s voting members discussed during their most recent monetary policy meeting. They offer valuable insights into the economic and financial conditions that shaped the committee’s decision-making process on monetary policy and, more specifically, why they chose to hold interest rates steady during their May 1st meeting.

The most recent set of minutes, released last week, showed that many Fed members are concerned that the Fed’s approach to fighting inflation isn’t working. Several members expressed uncertainty about just how restrictive the Fed’s monetary policy really is, while others believed that the neutral rate of interest – the level of the Fed Funds rate that neither suppresses nor stimulates economic activity – may end up being higher than previously thought.

The minutes re-instilled doubt across financial markets, which backtracked – once again – from expectations of a near-term rate cut. Some players have even gone further and now consider a rate hike in the realm of possibility.

Our take: The minutes confirm what we’ve been saying for months: Financial conditions are loose – as illustrated by the Fed’s own gauge – than believed and don’t justify rate cuts. Are they so loose as to justify a rate hike? No, and they won’t be unless we see a resurgence in inflation pressures, which is unlikely given signals of a slowing economy and stable job markets. One of those two variables must change – jobs and/or inflation – for the Fed to change course from holding rates higher for longer.

Mixed Bag of Data Paints a Murky Economic Picture

The week was marked by a continuation of conflicting signals of economic health, a trend that has persisted for weeks. This suggests that the Fed will maintain a cautious approach and refrain from making any hasty decisions in the foreseeable future.

First up, a Fed survey – the quarterly Household Debt and Credit Report – revealed that the level of household debt in the US has reached an all-time high, causing an increasing number of borrowers to face difficulties in meeting their financial obligations. US household debt has increased to $17.69 trillion, up $184 billion, or 1.1%, from Q4 2023.

The data underscore the increasing financial burdens on American families during heightened inflation. With the continuous increase in the prices of essential items like food and rent, many households face financial strain. As a result, people are resorting to borrowing against their credit cards to cover necessities. Consumers have accumulated a staggering $3.4 trillion in debt since the pandemic, and unfortunately, this increased debt comes with significantly higher interest rates.

The survey showed that housing accounts for the largest portion of household debt, over 70%. While most homeowners are keeping up with their mortgage payments, more and more are choosing to access their accumulated home equity through home equity loans, which are now at their highest levels of usage since 2008. And why wouldn’t they? Homeowners currently have nearly $32 trillion in equity to potentially draw from, and $580 billion in outstanding home equity credit available, the highest amount in nearly 15 years.

Second, April durable goods orders exceeded expectations, but downward revisions to prior months dampened the outlook. Adding to the gloom was a growing disparity between core shipments and orders, which implies a cloudy outlook for future factory production. Increased borrowing costs have likely significantly impacted the cost of business Capex plans, especially for small businesses that are not hiring or expanding.

Third, the S&P Global May Purchasing Managers Index, which measures the performance of the manufacturing sector in over 40 economies worldwide, showed that the pace of US business activity reached its highest point in two years in early May, driven by robust growth among service providers and accompanied by a rise in inflation. The strong demand keeps inflation pressures alive, forcing the Fed to shy away from any near-term move to cut interest rates.

What to Watch: Fed’s Favorite Inflation Gauge Will Kill Any Hope of Near-term Rate Cuts

Here we go again. The days ahead will be filled with economic events and data that the markets hope will lead to some real, actionable conclusions on the timing and degree of Fed rate cuts this year. Unfortunately, markets will be disappointed. The Fed will remain between a rock and a hard place – wanting to cut rates but without any data justification to do so – for the foreseeable future.

With inflation still uncomfortably high, combined with a slowing but healthy jobs market amid a resilient economy, there is no reason for the Fed to seriously consider cutting interest rates, and there won’t be until the jobs market shows serious signs of weakness or inflation pressures stage some miraculous decline. For now, the Fed seems confident that the increase in immigration and productivity can effectively smother inflation pressures down to its desired 2% target with minimal impact on unemployment. Are they right? Time will tell.

This week, we’ll get a key gauge of such with the release of the Fed’s favorite inflation gauge: the core PCE deflator for April (Friday). Expectations are for a slightly lower number, which the Fed will cheer, but not low enough to shift the Fed’s mindset toward rate cuts.

Looking ahead, next week will be much more impactful for the direction of interest rates than this one, with May’s jobs report and an update to the Fed’s dot plot on tap.

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