Murky Economics to Keep Fed on Sidelines

Running the Numbers: Rates Rise Across the Curve Amid Murky Economic Picture

For the week:

2-year Treasury yield: up 8 basis points to 5.07%
5-year Treasury yield: up 7 basis points to 4.48%
10-year Treasury yield: up basis points to 4.35%
30-year Treasury yield: up 6 basis points to 4.43%
1-month Term SOFR: down 1 basis point to 5.32%

Where will SOFR be a year from now? 3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, traded flat at 5.40%. The implied yield on the 3-month SOFR futures contract 1-year forward (September ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, rose thirteen basis points week over week, to 4.87%, reflecting ongoing inflation pressures amid a murky near-term inflation picture.

How much higher will SOFR rise? The SOFR futures marke implies that 3-month SOFR is already near its peak, and forecasts that it will peak before year’s end at 5.47%, then decline consistently over the next year as the Fed eventually cuts interest rates in Q2 2024. 1-month SOFR? It’s expected to peak at 5.55% in December 2023, also per the current SOFR forward curve.

Will rate cap costs ever decline? Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, continued its month-long decline, now sitting at levels last seen in January 2023. Any decline in rate volatility helps to drive rate cap costs lower. However, rate volatility is still high historically, and until there are clear signs that the Fed is on a rate cutting tilt, rate cap costs won’t decline precipitously.

Elsewhere, equities gained this week on hopes that central bank tightening cycles are nearing an end despite higher bond yields, a stronger dollar and firm oil.  The price of a barrel of West Texas Intermediate crude oil rose $4.59 to $91.88 from $87.29 a week ago as Saudi Arabia and Russia extended production cuts. Special note on oil: if it keeps rising, it will put a major dent in the often predicted economic soft-landing sceanrio. The US Dollar and Gold both strengthened.

Mixed Inflation Picture Will Keep the Fed on the Sidelines

Core inflation (via the consumer price index, aka CPI) rose by 0.3% month-over-month in August. The catalyst for inflation’s “surge” was increasing price pressures in two categories: transportation services and gas prices. Other components either remained flat or declined, specifically used cars and rents, and most notably owners equivalent rent, one that the Fed watches very closely, which slowed to 0.38% from 0.49%.

For some perspective, core CPI increased in August by 3.4%, 2.4%, and 3.7% on a 1-month, 3-month, and 6-month annualized basis, respectively, compared to readings of 1.9%, 3.1%, and 4.1% in July. While the  one-month measure increased, longer-horizon measures – what the Fed is most focused on – moderated.

Our take: August’s CPI report presents the Fed with several challenges as it prepares to hold rates steady this Wednesday. The good news is that inflation pressures in rents and used cars, two industries where the Fed was expecting disinflation, are moderating even more than the Fed had hoped. The bad news is that Fed officials must now assess whether the jump in prices for transportation services is temporary, as well as decide whether to ignore the recent surge in gasoline prices. The mixed inflation bag tells us that the Fed will hold rates steady for the rest of the year, but the transportation nuance in August’s CPI data makes a hike in November more likely than it was prior.

Strong Retail Sales Are Not What They Seem

The strength of retail sales – critically important these days given that the US consumer is driving upwards of 70% of all economic activity – surprised to the upside in August, rising to 0.6%, versus a downwardly revised 0.5% in July. That was much stronger than the 0.1% expected. Spending on gasoline added to the gauge as prices at the pump jumped 10.6% in August. However, control-group sales, which don’t include things like cars, gas, food services, and building supplies, were only up 0.1%.

Our take: The recent spike in gas prices was the real reason retail sales jumped last month, as opposed to an increase in spending on things we’d really like to see, such as bars and restaurants, furniture, appliances, etc. which either declined or were flat last month.  The dynamic tells us that consumers’ declining excess savings, soaring credit-card balances, and a softening jobs market are starting to be seen in the data. We expect consumers to cut back on their spending even more in the coming months. Looking beyond this week’s Fed meeting, whether the Fed holds rates steady in November or December will depend on just how much consumers tighten their belts between now and then.

On our Radar: Could the UAW Strikes Impact the Fed’s Psyche?

In a first, the United Auto Workers (UAW) went on strike against all three of the major Detroit automakers on Friday. The strike could spark a pricey, protracted conflict over pay and job security.

Workers at three different factories – a General Motors Co. facility in Missouri that assembles Chevrolet Colorado pickup trucks, a Stellantis NV facility in Ohio that produces Jeep Wrangler SUVs, and a Ford Motor Co. facility in Michigan that produces Bronco SUVs – went on strike when the midnight deadline for a new contract passed. After several weeks of negotiations, the union and automakers are still far apart.

Auto workers strike? Who cares, right? Wrong. If the current walkouts continue for the next four weeks, the localized UAW strike that started on Sept. 15 will eliminate almost 13k jobs from the October jobs report, set for release on November 3rd. If the strike intensifies to incorporate all 150k union members from the top three automakers beginning at the end of this month and continuing through mid-October, the October jobs report could show that no new jobs were added at all throughout the month. Even though jobs will rebound by the same amount once the strike ends, the uncertainty it generates and the lost production could increase recession risks, which are already high due to the Fed’s previous interest rate hikes. Such a scenario would put increasing pressure on the Fed to seriously contemplate a rate cut. In short, ignore the strike at your peril.

What to Watch: No Fed Hike This Week, But November is Now a Toss Up

Recent data on the US economy has sent conflicting signals. One the one hand, inflation is still falling in the most important categories and forward-looking gauges suggest that the jobs market is softening, and consumer spending is cooling; all good stuff if you’d prefer the Fed not hike interest rates any further. On the other hand, other gauges and price data imply that America’s economy appears to be resilient, and may even be accelerating, the siren song for a re-ignition of inflation pressures and ultimately more Fed rate hikes. As such, the Fed will sit on its hands at this Wednesday’s policy meeting, hoping the smoke will clear up in the coming weeks, allowing it to gain a clearer picture of the economic situation before the it’s next policy meeting on November 1st.

In the meantime, the Fed will release a revised version of its widely viewed dot plot during this Wednesday’s meeting, and markets will conclude that most Fed members still expect one more rate hike before year’s end. Although the dot plot has proven to be a terrible predictor of what the Fed actually does, markets still pay attention to it regardless. This week is no exception, given the reluctance of late for Fed Chair Powell and his colleagues to offer specific verbal guidance about the Fed’s policy outlook. Markets also await the revised dot plot to tell them when and how many rate cuts the Fed has penciled in for 2024. Back in June, the Fed had penciled 1% of rate cuts for next year. However,  given the mixed economic picture that’s emerged since then, we suspect that the 1% in projected cuts for next year will be reduced to 0.75% in rate cuts at most. Swaps markets mostly agree with us; traders see the effective fed funds rate – currently at 5.33% – falling to about 4.49% by the end of 2024.

What could drive the Fed to hike once more? Continued strong economic and job growth, maintaining price pressures on goods and services.  However, they will be keenly assessing the degree of economic disruption caused by the United Auto Workers strike and a likely government shutdown later this year. Unfortunately for the Fed, any economic data released before the their November 1st meeting won’t reflect the economic consequences of either event, likely keeping them guessing, hence our call for no hike or cut at that meeting as well. As for the likelihood of a rate cut, the uncertainty a prolonged strike and/or a government shutdown would cause – and their ensuing job market impacts –  could spark a economic downturn just as the lagged effects of the Fed’s past rate hikes take hold.

Strategy Corner: Buying Out Your Interest Rate Floor

Due to the massive rise in floating interest rates (e.g., SOFR) over the last year, most lenders have ratcheted up index floors when extending or modifying their floating-rate loans. Now that the Fed will soon shift to cutting interest rates, a borrower should be increasingly focused on any floors they have in their loans, and how these floors may limit the borrower’s ability to participate in falling floating interest rates/reducing their interest expense.

SOFR floors we typically see in loan agreements these days range from 1% to 4%. Of course, borrowers won’t be affected by the floor if SOFR is above it (with SOFR now at 5.30%ish, the floor is a non-issue until SOFR falls below the floor), but they would likely forgo interest savings should the Fed start cutting rates sooner or more aggressively than expected.

If your floor is SOFR 3.50% or higher – where SOFR is expected to bottom once the Fed is done cutting – you may want to consider buying out the floor now. The cost of doing so is completely dependent on the loan economics, but just know that it can be done, and the cost is usually palatable given the potential interest savings that can be achieved in doing so.

Curious if buying out a floor makes sense for your transaction? Contact us at us@derivativelogic.com or call 415-510-2100.

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