Positive Data Shatters Rate Cut Dreams

What You Missed

Data and events over the past week signaled that there may be far fewer Fed rate cuts this year than you’d like, as another blowout jobs report confirmed America’s resilient economy and manufacturing data implied the last mile in the Fed’s inflation fight will be a long one. We continue to expect the Fed to cut no sooner than July and for the Fed to come through with two rate cuts this year at most.

Our Interest Rate Hedging 101 on-site training is now approved for Continuing Legal Education (“CLE”) credits in many states, notably California, New York, and Texas.  Want to give your legal team a solid understanding of macroeconomics, interest rates and the best practices of hedging?

Give us a call at 415-510-2100 or Click here to arrange a session and receive CLE credit. It’s free.

Running the Numbers: Rates at Year-to-Date Highs on Jobs Data

Looking for live market rates and historical interest rate data? Check out our Interest Rate Dashboard.

For a time, the financial markets and the Fed briefly aligned in their views on the pace and timing of interest rate cuts. It was a short-lived affair, and Treasury investors are feeling the consequences. Market expectations have now flipped after spending much of this year making bets that were more extreme than Fed officials. They’re now forecasting about 70 basis points of rate cuts this year, compared to the 75 basis points signaled by the Fed during its March 20th meeting.

The yields on Treasury debt with maturities ranging from five to 30 years reached their highest levels of the year last Friday. The 30-year yield has surpassed 4.5%, while the benchmark 10-year note rose by ~16 basis points over the last two days, marking its largest jump since early February, reflecting strong economic data that point to strength in the economy, reducing the need for interest rate cuts.

It has been five months since the Fed’s apparent shift towards rate cuts in early November. Given how well the economy is performing, to wonder about just how restrictive the “high” interest rates we’re living with really are, is becoming a valid line of inquiry. Disregarding  inflation for a moment, the Fed has never cut rates with an economy like this. Certainly, interest rates have had a significant impact on housing, commercial real estate, and related sectors. However, when enthusiasm and optimism have become excessive in other areas of the economy, solely examining the level of interest rates might not be telling the whole story. 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, a more useful gauge of hedging costs than 1-month Term SOFR, fell one basis point 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 – and by extension, hedging costs –  to be a year from now, rose seven basis points week-over-week, to 4.48%, reflecting the “higher for longer” view permeating rate markets.

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 a couple of times in 2024. The forward curve projects that 1-month Term SOFR will steadily decline from here on out, eventually bottoming out near 3.67% in November 2027.

Where is the 10-year Treasury yield headed? The 10-year Treasury yield forward curve implies that the yield will bottom out at 4.32% in January 2025 – it’s sitting at 4.43% right now, and posted a 4.99% 12-month high back in October –  then stage a slow and steady sequential rise. 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, rose week over week, but still sits near a two-year low. 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 useful tool to provide an estimate, but if the expected start date is a couple months away or amortizing/accreting, give us a call for true indicative pricing based upon the specific economics.

Elsewhere, equities were lower on the week amid rising interest rates and firmer oil prices. The price of a barrel of West Texas Intermediate crude oil rose $2.76 from this time last week to $86.41, as the US dollar weakened, and Gold strengthened to an all-time high of $2,329.75.

Another Blowout Jobs Report Has Killed Your Rate Cut Dreams

Headline jobs blew away everyone’s expectations, jumping 303k in March compared to a downwardly revised 270k in February. The household survey of employment increased by 498k in March, posting a positive U-turn from declines in both January and February. The surge in total employment lowered the unemployment rate to 3.8% from 3.9% in February. Curious why there are two employment surveys? Here’s your answer. Which is more accurate in gauging the true state of the jobs market? How can we have both strong economic growth and falling inflation? Those are hotly debatable topics, especially given the surge in immigration over the past two years amid consistent declines in inflation. While we won’t go into it in this Straight to Smart newsletter, feel free to dig into it here, here,  here, and here.

The three industries logging the largest job growth were construction (39k), government (71k), and health care (72k). However, know that job gains weren’t spread out broadly. In most other major industries, such as manufacturing, mining, wholesale trade, transportation and warehousing, information, finance, and professional and business services, job growth was small or flat month over month.

Average hourly earnings, a.k.a. wages, increased 0.3% in March, up from the upwardly revised 0.2% in February. Additionally, the average work week grew, with an average of 34.4 hours worked (versus 34.3 in February). This resulted in a 0.6% increase in average weekly earnings for the month.

Another take on wages: wage growth is now humming along at 4.1% on an annual basis; that’s notably higher than the 3.1% annualized consumer price index (CPI), the prevailing measure of inflation. That tells us that consumers – who alone are responsible for ~75% of all US economic activity – have plenty of momentum behind them to continue spending despite high prices, keeping the economy motoring along. This wage growth versus CPI dynamic has existed since May of 2023, lending one possible answer to questions about how the US economy could be so resilient after 5.25% in Fed interest rate hikes since May 2022.

Bottom line: The Fed will view the March jobs data favorably, no doubt, and take away a feeling that the economy is still inflationary, presenting yet another reason to delay the start of its rate-cutting cycle. The rise in incomes and spending doesn’t bode well for inflation’s continued decline toward the Fed’s 2% target, despite clear evidence of a two-tiered economy – lower earners feeling the full brunt of inflation, and higher earners enjoying the fruits of record high equity markets. Layer on persistent evidence that financial conditions remain quite accommodative despite high interest rates and it’s logical to conclude that the Fed has no reason to cut interest rates anytime soon.

This means that longer term Treasury yields – like the 10-year – will likely continue to tick higher, driven by a growing expectation that the US economy will experience a “no landing” scenario, where the economy continues to grow at a moderate pace, rather than stall (a “soft landing”) or shrink (a recession). If inflation above 2.5% is the new normal, a 4.5% 10-year Treasury yield is about right. Should it hit 5% however, the equity market rally will be in danger.

It’s all just a continuation of financial markets caving to what the Fed has been saying since the start of the year: that rate cuts will be fewer and later than financial markets have forecasted, and that the Fed’s “terminal rate” – the level of the Fed Funds rate that neither depresses nor stimulates the economy – will end up being higher than most expect. At the end of the day, a “no-landing” scenario with a Fed on hold is probably better than a recession. But if the US economy reaccelerates, all bets are off and even higher Treasury yields become likely.

Manufacturing Sector Expands for the First Time Since September

Against forecasts of a far more modest rise to 48.3, the headline Purchasing Managers Index (PMI); among the most reliable leading indicators of the supply and demand for goods and by extension, the health of the US economy; jumped into expansionary territory (>50) for the first time since September 2022, registering 50.3 in March (vs. 47.8 prior).

The headline was driven by an increase in new orders, which saw a rise to expansionary territory at 51.4, up from 49.2 in February. Other demand-side factors showed greater consistency: The rate of decline in the order backlog remained consistent, as did the rate of increase in export orders.

Inventories declined at a faster rate compared to February, indicating a positive shift in demand. However, it seems that businesses are deliberately depleting their inventories to avoid price cuts and reduce financing costs. The dynamic will likely feed into inflation staying elevated, and by extension, giving the Fed yet another reason to delay rate cuts.

Bottom line: While it’s foolish to form an opinion off one set of economic data, on the surface it’s yet another set of data that feeds into the “no rate cut anytime soon” narrative.

Fewer and Later Rate Cuts = More Credit Distress

Global corporate bond and loan distress is on the rise once more, a direct result of delayed expectations of Fed rate cuts. This week’s increase in Treasury yields has put additional pressure on the most vulnerable borrowers, suggesting that more credit challenges may be on the horizon.

What to Watch: Inflation Above 3% to Cement No Landing Scenario

The March jobs report, with hiring surpassing expectations and the unemployment rate declining, has raised concerns about a potential delay in the start of the Fed’s rate-cutting cycle.

Attention in the week ahead now shifts to assessing the Fed’s success at fighting inflation via the March consumer price index (CPI, Wednesday). It is expected that the data will indicate a small decline in the monthly rate of core inflation to 0.3% – a level that aligns with the Fed’s annual core Personal Consumption Expenditures (PCE) inflation goal of 2.0%. If headline inflation remains around 3.0% (annual) throughout the year, the Fed should be able to cut rates in late summer due to ongoing disinflation in the core measure.

Financial markets will also be laser-focused on the thoughts of Fed voting members regarding recent data. The minutes from the Fed’s March 20th meeting (Wed.) will provide insights into how members felt about the mixed data picture which led to its decision to stand pat on interest rates, and how much they really believe in the current “no landing” economic narrative.

We suspect that the Fed isn’t eager to cut interest rates, and has a positive outlook on the economy, with a low risk of recession and confidence in its continued post-covid recovery.

See You at NAFOA

Derivative Logic is a sponsor at the upcoming Native American Financial Officers Association (NAFOA) April 29th and 30th in Hollywood, Florida.  Rex Evans will be in Atlanta May 2nd and May 3rd and Jim Griffin in New York.  Please let us know  – us@derivativelogic.com – 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.

Click to check out our Market Data pages and Calculators

Interest Rate Dashboard
Forward Curves
Interest Rate Cap Calculator
Defeasance Calculator
Yield Maintenance Calculator