Murky Data to Keep Fed on Sidelines
What You Missed
The latest read on inflation showed that it seems to have finally cooled to a level consistent with the Fed’s 2% target, leading financial markets to double down on their bets for a rate cut as soon as March and layer on even deeper rate cuts through the rest of the year. The fly in the Pinot Noir? The resilient US economy, which, while showing signs of slowing, isn’t doing so fast enough to warrant the level of rate cuts projected by the markets. We agree that rate cuts are coming, but still expect the first to occur later – in May – and that most of this year’s cuts will come in the second half of the year as the Fed takes its time amid a resilient US economy.
Click here to watch our Interest Rate Outlook livestream, reconrded on this January 11th, 2024. Get a smart start to 2024 with our comprehensive overview of the important influences behind the interest rates impacting you and your business. You can also download the presentation slides to share with your organization.
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?
Running the Numbers: Rates Lower as Markets Double Down on Rate Cut Bets
Looking for live market rates and historical interest rate data? Check out our Interest Rate Dashboard.
The 2-year Treasury yield fell to its lowest point since May as expectations that the Fed would cut rates multiple times this year were bolstered by an unexpected drop in producer prices. A week ago, traders were pricing in a little over 50% chance of a Fed cut in March; now, they are pricing in a 70% chance. It’s puzzling to understand the rationale for such skewed wagers, even considering the significant slowdown in inflation and the cooling of job growth. In fact, the most recent data on payrolls and consumer prices surprised to the upside, muddying the outlook, indicating that the Fed is still probably not entirely convinced that its strategy of bringing inflation back to its 2% target has been successful. The question now? What would it take to force financial markets to back off their extreme rate cut bets.
For the week:
2-year Treasury yield: down 17 basis points to 4.20%
5-year Treasury yield: down 8 basis points to 3.91%
10-year Treasury yield: down 1 basis points to 4.03%
30-year Treasury yield: up 7 basis points to 4.26%
1-month Term SOFR: down 1 basis point to 5.33% (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? 3-month (CME) Term SOFR, a more useful gauge of hedging costs than 1-month Term SOFR, fell three basis points to 5.30%. 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, fell eighteen basis points week-over-week, to 3.43%, reflecting the conviction of near-term rate cuts bets.
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 3.08% in November 2025.
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 firmer on the week despite an uptick in US consumer prices and retaliatory strikes by US and British forces against Houthi militias in Yemen. The raids came in response to repeated attacks against commercial shipping and US naval forces in the region and helped keep the price of a barrel of West Texas Intermediate crude elevated at $72.89. The US dollar and Gold both strengthened.
Inflation Data Paves Road to Rate Cuts
The headline Consumer Price Index (CPI) – a survey of the prices for what households are buying – increased by 0.3% in December (compared to a 0.1% increase in November), exceeding market expectations. The year-over-year change increased to 3.4% (compared to 3.1% prior). Core inflation – which strips out prices of food and energy products like gasoline – held steady at 0.3%, which was also higher than anticipated. The core CPI increased 3.8%, 3.3%, and 3.2% on one-, three-, and six-month annualized bases, respectively (compared to November readings of 3.5%, 3.4%, and 2.9%). These metrics are used by Fed officials to assess the momentum of inflation, which, according to the data, accelerated in December, the exact opposite of what the Fed had hoped for.
On the flip-side, inflation measured from the perspective of the businesses that sell the goods and services that households buy – the Personal Consumptions Expenditures (PCE) index – inflation is already below the Fed’s target. Core PCE- which also strips out prices for food and energy products – increased 1.7%, 1.4%, and 1.8% on an annualized 1-, 3-, and 6-month basis in December (compared to 0.7%, 2.2%, and 1.9% in the previous month), all of which are below the Fed’s 2% target.
Astute readers should be asking: Why is core PCE inflation softer than its CPI counterpart, even after core CPI just surprised to the upside? Aren’t CPI and PCE measuring the same thing, just from opposite perspectives? The short answer: It’s complicated. The reason for this mismatch is a downward drag caused by important components that are considered in the fundamental PCE calculations. For instance, while PCE’s domestic airfares category increased relative to the CPI’s counterpart, the PCE’s medical-care services categories grew more slowly than the CPI’s. Additionally, in contrast to the CPI version, the PCE measure gives core services, which don’t include housing rents, twice as much weight as car prices, where inflation accelerated.
Why you should care: One shouldn’t use the CPI version of these core categories as a signal of the true state of inflation. The Fed doesn’t, and neither should you.
Moving on to the gauge of inflation the Fed considers the most when forming its monetary policy: the core PCE deflator. We’ll get into the weeds here, so if a deep dive into inflation gauges isn’t your thing, skip to the “Bottom Line” paragraph at the bottom of this section.
The core PCE deflator is a subset of PCE that measures the pace of inflation based upon personal consumption, and the “deflator” is simply a ratio of the value of all goods and services produced in a particular year at current prices to that of prices that prevailed during a base year.
The core PCE deflator isn’t due for release until January 26th but can be estimated accurately from the PCE and CPI data. Based on these data points, the core PCE deflator for December was 0.14% (vs. 0.06% prior), and 2.9% compared to a year earlier. The year-over-year change in 4Q24 was likely 3.1%, less than the 3.2% forecast made by the Fed in their most recent .
Bottom line? At its current pace, the Fed’s preferred inflation gauge should come very close to its 2% target in the spring. It’s one of the reasons the reason why financial markets are falling all over themselves to bet on a March rate cut. Coupled with a slower deterioration in the jobs market, but amid an overall resilient economy, we’re guessing the economic sweet spot won’t gel until a bit later, and for the first Fed rate cut to come at the Fed’s May 1st meeting.
What to Watch: A Resilient Economy or One on the Verge of Recession. Which is it?
As we stated in our newsletters 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. Subsequently, Institute of Supply Management surveys and regional Fed business surveys (Empire State Manufacturing Survey, Tuesday; Philly Fed Business Outlook, Thursday) have revealed sharp drops in new orders and employment intentions. This troubling trend was confirmed by the household employment survey (-683k) included in the December jobs report. We’ll get the most recent reading of such throughout the week this week, which will likely confirm that the downward trend continues.
These markers, regarded as “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.
Which signals are correct, those coming from “soft” data or those coming from “hard” data? It’s a debate that’s raged for years, and for good reason: sentiment doesn’t always translate into action, and hard data are prone to significant revisions, just look at the consistent, downward revisions to the jobs report and other key hard data sets of late. What’s a forecaster to do? Given that it usually takes a while for revisions to the hard data to be published, our view is ultimately more influenced by the “soft” survey data at this point in the cycle, which historically has proven more accurate in capturing turning points in the economy.
The weak “soft” data of late is telling us that a shallow, brief recession could be upon us. One that may not be labelled as such, but rather an economic environment where anemic growth and rising unemployment persists. In short, the slow months ahead may not be called a recession officially, but it could sure feel like one with GDP orbiting 1%, much slower than the 2.6% seen last year, and with a meager 60-70K in new jobs being added each month this year, down from the 225k monthly average in 2023 and far below the 399k average in 2022.
Ultimately, the Fed’s assessment of the economy is more important. The most rate-hike, high interest rate-loving Fed member, Governor Michelle Bowman, stated last week that she is keeping a careful eye on revisions made to hard data from previous months. This tells us that some at the Fed are also concerned that the hard data might be misleading.
In the meantime, the slate of hard data on this week’s calendar should give you some comfort. Retail sales (Wednesday) should indicate that spending isn’t plummeting, and unemployment claims (Thursday) are likely low. Industrial production (also Wednesday) is likely expanding again after months of contraction.
All told, the murky data picture tells us that the Fed will take its time in executing the first rate cut, and despite market expectations of extreme cuts, that murkiness will erode the Fed’s confidence, pushing the first rate cut to May.
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 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.