No Cuts as Inflation Progress Stalls

What You Missed

The latest readings on inflation and retail sales surprised to the upside, sparking a collapse in expectations for interest rate cuts, with financial markets now pricing a once unthinkable scenario: no interest rate cuts in 2024. This new view comes with high and rising Treasury yields that have surged to their highest levels of the year.

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Running the Numbers: Rates Lurch Higher on Possibility of No Fed Rate Cuts this Year

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US yields surged to their highest levels of the year this morning after traders were dealt the nasty surprise of a third straight month of sticky inflation. Weak demand at the Treasury’s recent sales of long-term bonds provided even more evidence of bearish sentiment. However, rising tensions in the Middle East slowed the slide in yields as investors sought safety in US Treasuries.

The recent developments highlight a swift change in the global bond markets, which previously anticipated six quarter-point rate cuts from the Fed, beginning in March. There is growing concern among investors as Treasury yields experienced their largest single-day rise last Tuesday since August 2022, following the release of inflation data that exceeded expectations for the third consecutive month.

It’s clear that a 10-year Treasury yield near 4% and a red-hot stock market aren’t compatible with inflation declining to the Fed’s 2% target. Hence, we will likely need to see Treasury yields hold near their highs to see core inflation sustainably below 3%.  When it does, the Fed will have a choice: accept inflation levels near 3% as the norm or move back toward rate hikes to drag inflation down further.

As such, interest rate swap traders tweaked their expectations for the timing of the first rate cut, moving it beyond 2024. Meanwhile, Wall Street strategists, including Goldman Sachs, have also revised their forecasts toward a similar expectation.

For more on this topic, check out our Q2 Interest Rate Outlook.

For the week:

Where will SOFR be a year from now? 3-month (CME) Term SOFR  rose one basis point to 5.32%. 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 – and by extension, hedging costs –  to be a year from now, rose a whopping 32 basis points week-over-week, to 4.80%, reflecting financial markets that have thrown in the towel on hopes for any near-term interest rate cut.

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 at least once in 2024. The forward curve projects that 1-month Term SOFR will steadily decline from here on out, eventually bottoming out near 3.78% in May 2028.

Where is the 10-year Treasury yield headed? The 10-year Treasury yield forward curve implies that the yield will bottom out at 4.45% in December 2024 – it’s sitting at 4.60% right now, and posted a 4.99% 12-month high back in October –  then stage a slow and steady sequential rise. While the forward curve isn’t a forecast – it’s proven to be a horrible predictor historically – it does give one a peak at the market’s thinking at present. At the end of the day, we suspect that a 10-year Treasury near 4% – assuming the Fed is ultimately successful in bringing inflation down to its 2% target – will be Fed Chair Powell’s long-term legacy.

When will rate cap costs decline? Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, leaped higher week over week on the back of rising tensions in the Middle East, now sitting at a 2-month high. Rate cap costs continue to hover 25-30% below their peaks and will likely continue their downward path as the first Fed rate hike gets closer. Curious what a rate cap costs? Check out our rate cap calculatorThe calculator is a valuable tool to provide 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 for true indicative pricing based upon the specific economics.

Elsewhere, equities were lower on the week amid renewed fears that the war in the Middle East could widen and that future interest rate cuts will be smaller and later than anticipated. The price of a barrel of West Texas Intermediate crude oil fell $1.38 from this time last week to $85.05, as the US dollar and Gold both strengthened.

The Fed Isn’t Cutting Rates in June or July and Probably Not Even in September

The Fed’s progress at fighting inflation by keeping interest rates high – is stalling. Both the headline and core consumer price index (CPI) remained steady at 0.4% in March. Year-over-year, headline increased to 3.5% (compared to 3.2% in February), while the core inflation remained steady at 3.8%. On one-, three-, and six-month annualized basis – metrics the Fed uses to gauge inflation’s momentum – core CPI rose 4.4%, 4.5%, and 3.9%, respectively (vs. February’s 4.4%, 4.2%, and 3.9%, respectively).

Inflation’s stickiness is showing up in purchases of items we all use every day.  Energy prices added eight basis points to the headline number. Gasoline prices rose 1.7% (vs. 3.8% prior) on a seasonally adjusted basis, while electricity costs rose 0.9% (vs. 0.3% prior). Aside from energy, prices for services also fed into inflation’s rise last month.

A strong surge in the cost of transportation services, specifically vehicle maintenance and car insurance, played a significant role in maintaining high inflation in core services. The rising trend in these categories probably has a way to go, as it is a result of the continued impact of high car prices over the past two years. The cost of auto insurance, which has risen over 20% year over year since March 23’, is driving headline CPI higher to the tune of 0.6 % and is expected to keep up the pressure all year.

Housing rents followed their expected path lower. CPI’s Rent of Primary Residence increased by 5.67% year-over-year, its lowest reading since May 2022. Inflation in owners-equivalent rent (OER) increased by 0.4% in March, lower than the 0.46% increase seen in February. Rent plays a significant role in shelter costs, accounting for over one-third of the CPI. Based on current market trends, it is expected that both OER and primary-rent inflation will continue their gradual decline throughout the year, with overall housing inflation settling near 4.0% by the end of the year.

Bottom line: Excluding shelter costs, the year-over-year rise in the CPI stands at 2.3%, just slightly above the Fed’s 2% target.  Nevertheless, due to persistent inflation pressures in other categories, it’s increasingly apparent that the Fed will face a hard time getting inflation back to target. While the March headline and core CPI readings align with February’s, the Fed will place more importance on the March data given that inflation pressures usually decline this time of year, not increase.

When combined with the March’s blowout jobs report, there is zero reason for the Fed to cut interest rates anytime soon. As such, the first rate cut won’t show up any sooner than September, perhaps not until December. In the meantime, we’re watching the factors that will drive inflation’s direction for the rest of the year. Upside risks include geopolitics (Israel/Iran), energy prices, and the restrictiveness of financial conditions. Downside risks include weakness in China’s economy, deterioration in commercial real estate markets, banking sector stress, and the potential for a surprise weakening in the jobs market.

What to Watch: Stubbornly High Inflation May Be Slowly Breaking the Almighty Consumer

Strong household spending (Retail Sales, up 0.7% in March vs. an upwardly revised 0.9% prior) continues to play a starring role in keeping the US economy motoring throughout the past year, despite the Fed’s decision to hike rates by 525 basis points and keep them high. However, the consumer’s spending appetite – responsible for over 70% of all US economic activity – may be about to hit a speed bump.

Consumers are seeing few meaningful economic developments, and inflation remains a concern. Evidence of such was seen in last week’s consumer sentiment data, which showed a deterioration in consumer’s hopes for the future via persistently high prices for basic needs like energy and housing, uncertainty over the timing of the Fed’s first interest rate cut coupled with steadily eroding standards of living. For now, when combined with this morning’s positive report on retail sales, consumers remain conscious of high interest rates, but growing incomes continue to support their daily consumption. On the flip side, the wealthiest 20% of households have experienced significant financial gains due to the substantial increase in balance sheets during the pandemic and the subsequent stock market rally that began last December.

The billion-dollar question now is if this two-tiered economy can be maintained and, if not, what the ramifications could be. It’s widely understood that extreme concentrations of wealth smother aggregate demand for goods and services over the long run, and we may now see some of its early signs. Since the middle of last year, there has been a noticeable increase in aggregate consumption compared to income. This has resulted in individuals borrowing money or depleting their savings to cover the extra spending. However, there is a point where this trend reaches its limit. The credit-card delinquency rate is on the rise, reaching its highest level since 2012, as reported by the Philadelphia Fed. This indicates that consumers in the lower tier of the economy may be approaching their spending limit.

Perhaps that is why the new orders sub-indexes of regional Fed surveys, such as the Empire and Philly Fed, have been quite disappointing this year. The inventory-to-sales ratio (business inventories – Monday) has gradually increased. The potential decline in orders may disrupt the recent progress in industrial production (Tuesday). Consumption is projected to experience a notable slowdown in the second half of 2024 due to the diminishing effects of the equity market rally.

See You at NAFOA

Derivative Logic is a sponsor at the upcoming Native American Financial Officers Association (NAFOA) in Hollywood, Florida, on April 29th and 30th. Rex Evans will be in Atlanta on May 2nd and 3rd, and Jim Griffin will be in New York. Please let us know——if you would like to meet with us.

Use of Swaps is on the Rise

We are seeing an uptick in bank balance sheet loans and interest rate swaps to fix the variable rate.  An interest rate swap has more nuances and complexity than interest rate caps.  Give the capital market experts at Derivative Logic a call before entering into a swap or signing the ISDA.

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