Rate Cut Hopes Aren’t Dead Just Yet

What You Missed

Last week’s weak activity data was largely ignored by the financial markets, who instead took their cues from worse-than-expected data on inflation. The Fed rate cut guessing games continued, with markets now showing just a 31% chance of a May rate cut, roughly half of what was expected early last week. Although a later move by the Fed is looking more and more likely, we’re still expecting the first rate cut in May for now.

Running the Numbers: Rates Jump on Blowout Inflation Data

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Treasury yields were spurred toward their highest levels this year after a gauge of wholesale price inflation rose more than forecast, further squashing market expectations for how much the Fed might cut interest rates this year. The producer price index (PPI) was released after the consumer price index (CPI), which also increased more than anticipated in January. Although they have stated that rate cuts are likely this year, Fed officials have stated that before acting, they need more proof that inflation is headed sustainably toward their 2% target.

Swap contracts that forecast the Fed’s actions reduced the likelihood of a rate cut in June from nearly 100% to roughly 69%. The now estimated 100 basis points in rate cuts for all of 2024 is getting close to the Fed’s own 75 basis point projection. Looking ahead, the rate cut guessing game will continue for now, as markets and the Fed both wait for key economic data to hone their positions in the coming weeks. We’re holding our expectation for a May rate cut for now, but if the inflations gauges run hot again next month, we’ll reassess.

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, rose two basis points to 5.33%. 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 to be a year from now, rose 19 basis points basis point week-over-week, to 4.07%, reflecting the now pushed-back expectations for any near-term Fed 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 several times throughout 2024. The forward curve projects that 1-month Term SOFR will steadily decline from here on out, eventually bottoming out near 3.59% in August 2027.

When will rate cap costs decline? Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, fell once again week over week. Curious what a rate cap costs? Check out our rate cap calculator.

Elsewhere, equities were modestly higher on the week despite a surge in US inflation readings and dwindling anticipation of rapid rate cuts from the Fed. The price of a barrel of West Texas Intermediate crude oil rose $2.27 from this time last week to $79.20, as the US dollar weakened Gold both strengthened.

Latest Inflation Readings Have Crushed Your Rate Cut Dreams

Both the headline and core Consumer Price Index (CPI) accelerated in January from the previous month, rising 0.3% (vs. 0.2% prior) and 0.4% (vs. 0.3% prior), respectively. In year-over-year terms, headline inflation fell to 3.1% (vs. 3.4% prior), while core registered 3.9% (same as prior), far above the Fed’s 2% target.

On one-, three-, and six-month annualized basis – metrics Fed officials use to gauge inflation momentum – core CPI rose 4.8%, 4.0%, and 3.6%, respectively (vs. corresponding December readings of 3.4%, 3.3%, and 3.2%). Various Fed officials have indicated they focus more on the longer-term measures, e.g., the six-month annualized, which remains far higher than the Fed’s 2% inflation target.

The big jump in prices occurred in core services, which rose dramatically to 0.7% (previously 0.4%). Most of this increase was attributed to non-housing sectors, with core services, or “supercore” categories, which don’t include housing rents, increasing by 0.8% as opposed to 0.3% previously. Notably, the rise was driven by auto insurance and repairs as well as transportation services, especially airfares. Costs for medical care services also came in higher than expected.

For our commercial real estate readers, primary rents moderated some last month, though  owners-equivalent-rent (OER)  – the driving force behind inflation of late – increased by 0.6% (vs. 0.4% prior). For some perspective on that number, on a year-over-year basis, shelter costs peaked just above 8% in March 2023, then declined to 6.2% by the end of 2023. We expect the trend to continue, likely falling to the 4% neighborhood by the end of 2024. Yes, we know, many will say the BLS’s gauge of rents is flawed, showing higher rents than exist in reality, and by extension, keeping the Fed on the “higher interest rates for longer” bent longer than they should be. That may be true, but we didn’t hear you complaining when rents were rising, and the Fed showed no inclination to hike interest rates. You can’t have it both ways; just saying!

Flipping to the producer side of the inflation coin, due to a significant increase in the costs for services, prices paid to US producers increased in January more than expected, up 0.3% from December.  On a year-over-year basis, PPI rose a whopping 0.9% from a year earlier, exceeding all expectations. Core PPI, which excludes volatile food and energy components, climbed 0.5% from December, and 2% year-over-year – both topping expectations – driven higher mainly by increases in hospital outpatient care and portfolio management fees.

Bottom line: As the January CPI and PPI reports demonstrate, getting inflation back down to the Fed’s 2% target is proving to be difficult, and will probably take longer than anyone expects. A continued decline in inflation pressures for core goods is encouraging, as are the continuing declines in housing and rents. While we still expect the first rate cut to show up in May, if prices for core services stay high, we’ll likely push our first-rate-cut forecast to later in the year.

The Always Important Consumer is Tightening their Purse Strings

As expected, consumers – who alone are responsible for ~70% of all US economic activity – cut back their spending last month, after overspending during the holidays amid a chilly winter.  But even though interest-rate-sensitive categories saw the most of January’s spending contraction, consumers also tightened their belts in response to high borrowing costs and rising credit card balances and delinquencies.

Here’s the skinny: Despite expectations of a 0.2% decline, headline retail sales for January showed a slower-than-expected 0.8% decline. Also of note, the headline retail sales for last month was revised down from +0.6% to +0.4%. Excluding spending on cars and gas, retail sales decreased 0.5% month over month (versus +0.6% previously). Sales of the control group, which excludes spending on cars, gas, food services and building materials, fell by 0.4% (versus +0.8% last month). This was a more significant slowdown than almost anyone expected.

Bottom line: Reading between the lines, after spreading holiday cheer willy-nilly over the Christmas holidays, consumers are clearly becoming more frugal. Taking the CPI, PPI and retails sales reports together, they tell us that the Fed’s position is becoming increasingly precarious: It’s walking a tightrope to ensure inflation continues on the path to the 2% target without triggering a sharp deterioration in the economy.

What to Watch: Parade of Fed Speakers to Keep Hopes of Mid-year Rate Cut Alive

It’s a light data week with mostly events taking the spotlight.

Last week’s much-worse than expected CPI and PPI data will serve to cast the Fed’s favorite inflation gauge – the core PCE deflator – in an equally unfavorable light when it’s released on February 29th, likely coming in at a very hot 0.4% pace to start the year, up from 0.2% in December. At the same time, economic activity has surprised to the downside, with retail sales, industrial production, and housing permits all contracting in January.

Amid the constant onslaught of data and events, combined with financial market “experts” that have been caught wrong-footed in their rate cut forecasts, perhaps it’s time to attempt to sort the signal from the noise, and a looming parade of Fed officials will seek to do just that via their scheduled speeches this week. Grab your popcorn; Minneapolis Fed President Neel Kashkari, Philadelphia Fed President Patrick Harker, and Fed Governors Michelle Bowman, Lisa Cook, and Christopher Waller all have slots on the calendar this week, where they’ll likely downplay the importance of recent economic data reports while also being acutely aware of the subtleties of the blowout inflation data.

Outside of speeches, minutes from the Fed’s January 31st meeting is set for release on Wednesday and will likely demonstrate a consensus among the Fed members to cut rates at some point this year, with most of them likely concurring that the process can start before the 12-month change in inflation drops to 2%.

Takeaways: The MBA’s CREF24 Conference

Representing DL at the conference was Scott Croul, Carol Ng, Jim Griffin, and Rex Evans.  We had a great time meeting with old friends and making new ones.  At the conference and ensuing Hedging 101 seminars, there was much discussion about interest rate swaps and how they work to manage interest rate risk.  New to swaps? Here’s the skinny:

Only a bank can provide an interest rate swap, and the underlying loan must also be with the bank (there are exceptions, but the costs can be prohibitive).

A swap is used to synthetically fix a floating rate loan. Key considerations and benefits of a swap:

    1. The swap can have a term less than the maturity date of the loan.
    2. The borrower can determine the amount of the hedge. A 50% fixed and 50% floating is considered “risk neutral”.
    3. A swap can have a positive or negative market value over time and can be terminated prior to its maturity. If the existing swap rate is lower than current market swap rate with the same the remaining term, the swap has a positive market value and conversely a negative value if the fixed rate is higher.
    4. The bank must underwrite the exposure in the event there is a default. Unlike an interest rate cap, a swap is an obligation to pay a fixed rate in return for the floating index.
    5. There is an embedded swap fee to compensate the bank for the underlying default risk. This swap fee is fully negotiable, but the borrower/hedger typically has no idea what’s “reasonable”.  Employing the advice of an independent swap advisor is the only way to evaluate what an equitable fee should be.  Many factors play into the determination of the swap fee, and the process can be complex.
    6. Unlike an interest rate cap, which is always an asset, a swap is an obligation of the borrower, and they can’t just walk away from it if the underlying loan is paid off prior to maturity.

Prior to entering into a swap, the hedger must sign a document that sets the legal terms of the swap, a.k.a. the Schedule to the ISDA Agreement. Simply put, the Schedule to the ISDA is used to determine and manage the risks of a default. While these terms aren’t simple, they are negotiable. While you probably won’t remember reading this a week from now, remember this: NEVER, EVER sign the ISDA without proper review by an independent party.  The default language almost always favors the bank.

By fixing the entire loan balance up to the maturity date might seem the prudent way to mitigate floating interest rate risk. Often hedgers don’t consider factors that could result in substantial economic costs. Instead of mitigating interest rate risk, a borrower could be unknowingly adding risk.  Our recommendation? Always seek independent advice.

To learn more about interest rate swaps give us a call or schedule a Derivatives 101 session.

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