Murky Jobs Data Reveals Fed’s Dilemma

What You Missed

In a week filled with mostly second-tier economic data, more signals emerged that imply the Fed’s 500+ basis points in rate hikes are slowly having the desired impact of slowing the US economy. The billion-dollar question now: Will these emerging signals coalesce to prompt the Fed to cut interest rates by the end of the year?

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Running the Numbers: Rates Spurred Slightly Lower by Encouraging Inflation Data

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Treasury yields fell across the maturity spectrum week over week in response to the release of benign inflation data (see below), fueling predictions, once again, that the Fed may cut interest rates at least once by year’s end.

Yields on two-year Treasury notes fell to their lowest level in over a week, below 4.87%, from their high of nearly 5.00% early last week. This is significant as 1) 2-year Treasury yields are more sensitive to shifts in expected changes in Fed policy compared to longer-term maturities, and 2) they serve as a proxy for the cost of 2-year interest rate caps.

The 10-year Treasury yield dropped below 4.5% on Friday, following a peak above 4.63% early in the week. Zooming out, it’s consistently orbited around 4.5% over the month of May, held there due to a combination of weaker economic data and statements from various Fed officials that backtracked from the three quarter-point rate cuts implied by their dot plot. Fed officials will publish an updated dot plot at their next meeting on June 12th.

Swap markets are still pricing in just one rate cut this year: a quarter-point cut in December, with odds of a September cut hovering near 45%, slightly higher than the 40% seen this time last 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, fell just under a basis point to 5.34%. 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, fell 11 basis points week-over-week to 4.55%, reflecting lower Treasury yields and static hopes for just one Fed cut this year.

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 3.75% in June 2028, 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 4.40% in April 2025 and then stage a slow and steady sequential rise. Given that the current 10-year yield is just under 4.50%, the market has priced in basically no change in long-term rates for the next 10 months – a very unlikely scenario.  Ultimately, we believe 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 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, rose slightly week-over-week, hovering near a two-week low. Rate cap costs continue to hover 25-30% below their peaks and will likely continue on their slow, 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 little changed for the week. A barrel of West Texas Intermediate crude oil fell $3.03 to $79.75 last week as the US dollar strengthened and Gold weakened.

Latest Inflation Readings Are Encouraging, But Still Too High

Inflation data is released in two flavors: headline inflation, which measures price movements in all goods and services consumed in the economy, and core inflation, which excludes volatile (made so by trading in commodity markets) food and energy prices.

The core Personal Consumption Index (PCE), the Fed’s favorite inflation gauge (no, it’s not the CPI), painted an encouraging but muted picture that the Fed’s 500 basis points+ in rate hikes is having the impact the Fed wants. It increased by 0.25% versus 0.33% in March. Year-over-year, growth in the core PCE slowed slightly, coming in at 2.75% compared to 2.81% in March.

Supercore PCE  inflation – which excludes housing-related components and is what Fed Chair Powell has described as his favorite inflation gauge – dropped to 0.26% (compared to an upwardly revised 0.42% previously) mainly due to increased costs for financial services and insurance. The three-month annualized rate, useful in gauging supercore inflation’s directional momentum, fell to 3.6% (compared to a downwardly revised 5.4% previously). In comparison, the six-month annualized rate increased slightly to 4.1% (compared to a downwardly revised 3.78% previously).

Another slice of supercore PCE to look at is the year-over-year number, which at 3.43%, has been stubbornly stable since November, not what the Fed wants to see and not encouraging for any near term rate cut, leveling in a 3.3% to 3.6% range.

Finally, personal spending growth – a critical component to economic growth given that consumers drive ~70% of all US economic activity – slowed to 0.2% (compared to 0.7% previously). Spending on both goods and services fell, as the personal savings rate held steady.

Bottom line: Overall, the mixed inflation picture shows that inflation pressures are slowly dissipating, which is encouraging, but aren’t doing so fast enough to nudge the Fed toward rate cuts anytime soon. Given that other areas of the economy are mostly stable, the Fed will need to see a few months’ worth of data – at a minimum – which signal that inflation is declining markedly before seriously considering cutting interest rates. Throw in the likelihood of a heatwave this summer – and the higher energy prices / volatile commodity markets that come with it – and you have a scenario where inflation doesn’t fall quite as much as the Fed needs to justify a rate cut. All told, that likely puts the first cut sometime in the fall, at the absolute soonest. We don’t doubt we’ll see one until later in the year, like December, if we see a cut in 2024 at all.

The fly in the rose’? A cooling jobs market, which has yet to be seen but could be lurking around the corner….

Latest GDP Measure Implies a Soon-to-Slow Jobs Market

Downard revisions to Q1 GDP and GDI are signaling a slowdown in the economy, yet another sign that the Fed’s rate hikes are showing their teeth.  The data will likely give the Fed increased confidence that inflation won’t surge anew and may continue its downward trend.  Should it bleed into a slowing of the jobs market, the Fed may feel a greater need to cut rates in the coming months.

Real Q1 GDP was revised lower to 1.3%, down from the previous estimated 1.6%. For some perspective, Q4 2023’s real GDP was 3.4%. Real GDI, which measures the incomes of individuals and corporations, slowed to 1.5% in Q1 versus Q4 2023’s 3.6% (GDP vs. GDI:  What’s the difference?). The average of the two fell from Q4’s 3.5% to Q1’s 1.4%, notably lower than the Fed’s projection of 1.8%. Lastly, buried in the data were signals that firms’ profit margins are compressing, which could mean that a wave of new layoffs could lie in wait around the corner should those firms try to protect their profit margins. A sagging jobs market is critical for any real justification for rate cuts this year.

The bigger longer-term risk is stagflation – a combination of slow economic growth and high inflation – which, should it show up, would keep the Fed on hold even though it would desperately want to cut interest rates in a stagflation scenario. The risk of such is real and will keep longer-term Treasury yields, like the 10-year – hovering in the mid to low 4% range for now.

Oh yeah, don’t forget the Presidential election in November. It’s a time when the Fed likes to avoid tweaking rates in either direction to avoid the perception that it’s helping or harming the incumbent and, by extension, influencing the election outcome.

What to Watch: Jobs Report Takes the Spotlight

Once again, financial markets will focus on the single most impactful piece of economic data on interest rates: the monthly jobs report. The problem this time around is that the jobs data won’t show any clear direction and will keep markets and, more importantly, the Fed guessing whether interest rates are high enough to kill the inflation dragon once and for all without tanking the economy.

We see the Fed having two choices at this point: 1) Make fighting inflation its top priority by holding rates steady even amid a weakening of the jobs market and a slowing economy, thereby increasing the likelihood of a recession down the road, or 2) Cut interest rates on the first consistent signs of jobs market weakness even though inflation pressures are well above its 2% target, thereby prolonging the time it will take to get inflation down to its 2% target.

Either way, the Fed faces a dilemma, and we suspect they’ll opt for #2, as the collateral damage of choosing #1 is less desirable.

As for this week’s job report itself, it’s likely to present conflicting views of the jobs market. The headline survey is expected to reveal strong job growth. In contrast, the household survey is likely to signal a slight increase in the unemployment rate (Wondering why there are two employment measures? Here’s your answer).

Which jobs measure is a better predictor of the economy’s future direction? That’s a highly debated question, and the answer varies based on where we are in the economic cycle. The headline survey better reflects the state of the economy right now. However, the household survey is broader, and thus, offers a wider insight into the job market, demographic trends, and to us, where the economy is headed.

Recent data from the household jobs survey suggests a growing population and labor force, with a slight increase in employment. However, the unemployment rate has also risen, and part-time work has increased due to economic reasons, implying a slow and steady job market erosion.

Other data on tap this week – performance gauges on manufacturing and consumer’s appetitite for sevices –  will shed light on whether the economy could be slowly slipping toward recession or if the recent loss of momentum is just a blip.

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