No Catalyst for Near Term Rate Cuts

What You Missed

For the second consecutive month, May’s retail sales were weaker than anticipated, accompanied by a decline in housing starts and existing home sales. Taken together, the data are yet more signs that high interest rates are increasingly impacting the US economy. On the flip side, a surprise surge in consumer goods production signaled that producers expect a commensurate surge in consumer demand, a dynamic that’s just the opposite of what the Fed wants to see.  Is it enough to move the Fed closer to the first rate cut? The answer is no.

On Tuesday, June 25th at 10 am PT, quickly get Straight to Smart about what’s moving interest rates in the 3rd Quarter of 2024 and beyond!

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Running the Numbers: Rates Notch Lower on Bad News is Good News Data Dynamic

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Limp data on retail sales encouraged players in the interest rate markets to believe, yet again, that lower rates may be around the corner. However, few are willing to put their money where their minds are for fear that another opposing force may soon turn their hopes upside down. Their fears are justified.

On the surface, it appears that inflation and the jobs market are finally showing signs of cooling, prompting many to speculate that the Fed may cut interest rates as soon as September (the Fed Funds futures markets currently project a 64% probability of such). The fly in the rose’ is that even if the Fed does throw us all a bone and cut once or twice this year, the so-called “neutral” Fed Funds rate – the level of Fed Funds that neither suppresses nor stimulates economic activity – will likely end up being much higher than anyone expects. The belief is mainly due to 1) the ongoing resilience that the economy has shown despite the sudden and heavy burden the Fed’s 5.25% in rate hikes has laid upon us, and 2) the Fed won’t be able to cut rates all that much in the coming quarters for fear that inflation will rise anew.

For context, forward contracts referencing the five-year interest rate in the next five years, a proxy for where rates may settle over the longer term, have stalled at 3.6%. Although it has decreased from last year’s peak of 4.5%, it remains more than a percentage point higher than the average over the past decade and handily exceeds the Fed’s estimated 2.75%.  For those of you who like charts, it’s tough to deny that the 10-year Treasury yield has broken out of its four-decade downtrend:

The dynamic has created a floor under longer-term interest rates, like the 10 and 30-year Treasury yields, limiting just how far longer-term yields can fall. Layer on the US Treasury’s need to fund massive deficits, and the floor under long-term yields becomes even more solid.

It’s also possible that the Fed Funds rate, which currently sits at 5.50%, may not be as restrictive as it seems. It’s an argument we’ve been making for months now and is evidenced by the Fed’s own gauge that financial conditions are nowhere near restrictive as “high” interest rates imply, but are actually but quite loose.

We’ll explore this concept in tomorrow’s Q3 Interest Rate Forecast webinar. Haven’t registered yet? You can do so here.

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, traded flat at 5.34% for the second consecutive week. 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 three basis points week-over-week to 4.28%, reflecting lower Treasury yields and renewed hopes for Fed rate 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 3.48% in March 2028, up two 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 4.14% in June 2025 and then stage a slow and steady sequential rise. With all the US Treasury’s debt issuance on tap in the coming quarters , combined with middle class and high net worth households flush with investment returns keeping the economy humming, it’s tough to imagine a 10-year Treasury yield sustainably below 4.20%.

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, fell to a one-week high. Rate cap costs continue to hover 25-30% below their peaks and will likely continue 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 traded off record-high levels, taking a breather amid a week of mostly second-tier economic data and events. A barrel of West Texas Intermediate crude oil rose $0.33 to $80.68 as the US Dollar strengthened and Gold traded flat.

Retail Sales Data Implies Consumers Increasingly Seek Bargains

Retail sales for May increased by just 0.1%, well below consensus expectations of 0.3%. April’s retail sales figure was revised lower, to -0.2%. Excluding cars and gasoline, retail sales increased by 0.1% in May (versus a revised -0.3% in April), also well below the consensus expectation of a 0.4% increase. Retail sales in the control group, excluding vehicles, gas, food, services, and building materials, showed a modest recovery of 0.4% (versus a downwardly revised -0.5% in April), slightly below the consensus forecast of 0.5%.

Our take: Since consumer spending drives ~70% of all US economic activity, the pace of retail sales is an essential gauge of America’s economic health. While retail sales rebounded in May, the data shows that consumers are being cautious and restrained from spending for the second consecutive month, indicating that their ability to consume is becoming more limited due to high borrowing costs.

Keep in mind though that we’re living in a two-tiered economy; one where if you owe money, e.g., high credit card debt or an automobile loan, the Fed’s 500 basis-points+ in rate hikes have been painful for you, increasingly constraining your ability to spend freely as your covid-era savings have dwindled. However, if you own assets, you’re sitting pretty with the stock market, home prices and bond yields all up, allowing you and your cohorts to drive nearly half of all consumer spending. The problem with this mix is that riskier households just don’t make up large enough share to tilt the balance toward a signifcant, downward spiral in overall spending. Said another way, those housholds that are flush with stock and bond market returns, combined with ‘in-the-money”, 30-year fixed interest rate mortgages and high and rising home values, are driving the spending momentum, overwhelming the declines in speanding emanating from those with weaker household balance sheets.

It is unlikely the dynamic will change anytime soon, and when combined with loose financial conditions overall, means that the Fed has zero reasons to cut interest rates for the foreseeable future.

Realization of a Slower Pace of Fed Rate Cuts Dings Housing Starts

The decline in housing starts in May was much greater than expected, with a decrease of 5.5% compared to the consensus forecast of a 0.7% increase. For context, this comes after a significant surge of 4.1% in April.

The number of larger multifamily project starts (with five or more units) decreased by 10.3%, while single-family starts saw a more modest decline of 5.2%. However, a significant portion of the decrease in housing starts can be attributed to the decrease in the construction of single-family homes. Permit issuance declined 3.8% last month, lower than the expected 0.7% increase. May’s decline follows April’s 3.0% decrease. The decrease in permits was almost equally divided between single-family and multifamily projects.

Our take: The unexpected decline in May housing starts coincided with a decrease in expectations for imminent Fed rate cuts. The historically high cost of financing, coupled with ongoing demand pressures, will continue to stress the housing market.

What to Watch: Fed’s Favorite Inflation Gauge Will Encourage Them, But Not Enough to Cut

During the first half of the year, it appeared that the Fed’s progress in fighting inflation had stalled, as most inflation gauges rose consistently from their December 2023 lows. As a direct result, the Fed was forced to backtrack from its December 2023 pivot toward lower rates.

As nature would have it, stronger inflation pressures have forced those consumers with weak balance sheets to reassess their spending habits and reduce spending. As the cycle turns, some businesses have responded by lowering the prices of their goods and services. As such, this week’s bi-monthly release of the Fed’s favorite inflation gauge – the core PCE deflator (Friday) – will likely log its slowest monthly (0.1%) and year-over-year growth pace (2.6%) since March 2021.

Although financial markets would welcome such an outcome, it won’t be enough to push the Fed toward cutting rates anytime soon. Services categories – where the mighty US consumer spends most of their money – such as health care, are experiencing significant price pressures, while the rate of inflation in housing is decreasing (pending home sales, Thursday), it’s doing so only slowly.  After scanning inflation pressures in the goods and services landscape, it’s conceivable that prices aren’t falling fast enough to give the Fed confidence to cut rates AT ALL this year.

Given the Fed’s dual mandate of price stability and full employment, the impetus for rate cuts must come from a weaker jobs market. Thus far, the jobs market has outperformed expectations, posting a surge in new jobs last month, combined with strong showings in most of 2024. The unemployment rate, at 4%, sits at near-record lows, and is well below the long-term average of 5.7%. The string employment picture is driven by robust corporate earnings, which don’t show any sign of slowing. Even among distressed employers, massive layoffs just aren’t happening; investors are choosing to write down the debt of these debt-laden, stressed companies in exchange for equity. This allows the companies to remain going concerns and avoid mass layoffs.

Even if a weaker jobs market is somehow on the horizon, the Fed won’t cut based on just a couple months of weak job report prints; it will take a couple of month’s worth of data at the very least, especially when a weak jobs scenario is combined with still-high inflation. That puts the first rate cut at the end of the year at soonest and maybe not even then.

Keep in mind that the Fed is committed to getting inflation down to its 2% target, and has publicly said so many times. As such, any perceived back tracking from that target – amid a suddenly weak jobs market – would be a public relations disaster. What’s the Fed’s main weapon to slay the inflation dragon? Keeping interest rates higher for longer.

Strategy Corner: Customized Rate Cap Structures Yield Great Savings to Borrowers

We are seeing new bridge borrowing with required caps at strikes that are more in line with the market.  Many bridge facilities have accreting/amortizing schedules, which should be considered when structuring the cap.  Don’t fall asleep on it; a borrower can achieve substantial savings by using that same accreting/amortizing schedule with the rate cap.  We’ve helped numerous clients work with the lender to accommodate such.  A “step-up” cap is another reducing cap cost strategy.  For example, the first 2 years of the cap is struck at 5.00%, and the last year is 6.00%.   The last year of the cap is the most expensive, hence the higher, 6% strike brings down the overall cost of the cap dramatically.  Curious? Call us to discuss your unique situation.

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