Rates Sway After The FOMC

2022 Derivative Logic, Inc.

What You Missed: July ended with a mostly inverted U.S. Treasury (UST) curve, yields lower past 2-years, and ‘real’ inflation adjusted interest rates past 1-year, more deeply negative. Last month’s rate performance has the traditional markings of the Fed’s rate tightening process reaching a late stage. While it may look this way on the surface (inversions and lower medium & long-term rates), we believe this is not a rate set-up that should be trusted right now … the Fed has NOT tamed U.S. inflation.

Last week’s FOMC decision, economic data, and broader market outcomes highlight many of the crosscurrents confronting the U.S. interest rate outlook. The Fed delivered its second consecutive 75 bp rate hike as expected, and U.S. Treasury (UST) yields, from 3m to 10-yrs, fell unevenly with 2-yr rates down 9 bps to 2.88% and 5-yr lower by 17 bps to 2.68%. Many risk assets, including stocks and some commodities, increased amid speculative and fundamental underpinnings while the latest U.S. economic data further amplified both inflation and recession risks at mid-year.

Lower hedging costs

Interest rate volatility and implied future SOFR rates past 2022 fell further last week, and for July, helping to ease rate cap costs.

3m Term SOFR (CME) fell 1.5 bps last week to 2.543%, increasing 43 bps in July, while moving mostly sideways since mid-month. Futures imply the index peaking in Q4 ’22 @ ~ 3.25% then falling to 3.00% by mid-’23 and 2.50% by Q1 ’24. The declines suggest a reversal in Fed policy, to easing, next year. While this expected path is not absurd, it is premature to count on it in our view. Current sources of inflation are complex and have largely not yet abated – we remain concerned inflation may not roll-over conveniently, nor stay down, requiring a tougher policy response.

For July, financial conditions eased and set back the Fed’s inflation fighting efforts

In addition to higher interest rates, Fed policy is also counting on tighter (more restrictive) financial conditions to slow inflation. In July, market-based financial conditions mostly eased, setting back the Fed’s efforts to apply the monetary brakes. Stocks roared back last month, rising after strong earnings and last week’s post-FOMC meeting press conference which provided some hope of smaller rate hikes ahead. For July, the major U.S. stock averages had their best month of 2022, the S&P 500 was up 9%, and U.S. public equity market capitalization increased $3.6 Tn to $41 Tn, reenergizing the U.S. wealth effect to some degree … even if only temporarily.

Credit markets mostly improved. BB industrial spreads narrowed further last week and tightened decisively for July to levels last seen in early April. Pricing for leverage loans, the key non-investment grade asset class involved in CLOs, improved past mid-July and 30-year fixed mortgage rates, a key housing affordability component, fell 40 bps last month to 5.30% (Freddie Mac).

Last week’s U.S. data highlights maintain inflation vs recession concerns

Consumer confidence remained exceptionally weak in July, new home sales slowed further in June while pending home sales point to a further downtrend in the sales of existing homes. The first look at ‘real’ GDP for Q2 showed a weaker than expected contraction (-0.9% annual pace) on top of Q1’s -1.6% growth shrinkage while the pace of consumer spending slowed. The employment cost index, measuring wages and benefits, increased 5.3% YoY in Q2 vs 4.7% YoY in Q1. Wage growth has unlikely peaked. Initial weekly claims for unemployment insurance (4-wk moving average) increased for an 8^th straight week. The Fed’s preferred inflation measure, the PCE price index, rose further in June to 6.8% YoY (headline) and 4.8% YoY (core). The core measure is expected to continue rising.

FOMC hikes as expected but rates are still likely far from restrictive

The target Fed funds range now sits at 2.25 – 2.50% following the 4 consecutive Fed tightenings of 25 bps (Mar), 50 bps (May), 75 bps (Jun) & 75 bps (Jul). Much of the market focus after the July 27^th FOMC announcement centered on the Q&A session where Chairman Powell said the current rate level is “right in the range of what we (the Committee) think is neutral.” In our view, this comment does not change much about what Powell and his team need to do. The Fed Chair made it abundantly clear that the Fed’s key focus right now is to achieve price stability. To turn back inflation, policy needs to be restrictive and Powell noted, a few times during the press conference, that the Fed’s June Summary of Economic Projections (SEP) remain appropriate general guideposts for the Fed’s rate tightening path. June’s (SEP) Fed funds projections of 3.4% (end ’22) and 3.8% (end ‘23) are a good bit higher than what is priced into the Fed funds futures market currently. Powell concluded that future policy decisions, and updated SEP guidance, will depend on how the data unfolds over time without being more specific … the SEP will be updated at the conclusion of the next FOMC meeting (Sept 21).

We believe that if core inflation stays elevated at current (June) levels or accelerates, the SEP’s rate projections (in Sept) will not be reduced and implied yields in the futures market (’23 & ’24) for Fed funds and SOFR will have to rise from current levels, undoing July’s downward reversal, while lifting hedging costs.

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What to watch this week – data from a rate perspective

ISM’s July Manufacturing survey on Aug 1 and Services gauge on Aug 3 will provide recent business sentiment guidance on inflation, new orders, inventory, and employment. Job Openings data (JOLTS) for June on Aug 2 is expected to show fewer available job openings but still far more than the number of unemployed … signaling continued tightness in the labor market while the Aug 4 weekly jobless claims data is likely to continue to show some cooling in the job market ahead of the Aug 5 (Fri) high profile July employment report. It’s expected that fewer jobs were added last month (250k vs June’s 372k) while the unemployment rate remained unchanged at 3.6% for a 5^th straight month – an outcome that does not align with recession concerns.

Opportunity to hedge in early August?

If July’s employment report (Fri) disappoints with either an uptick in the unemployment rate or fewer than expected payroll gains, term yields and future implied SOFR rates may move lower helping to further reduce interest rate hedging costs. Looking ahead to July’s CPI print (Aug 10) – likely the most consequential data this month to influence hedging costs – the focus should shift towards the core (ex-food and energy) measure.

Big Picture for August – Focus on Core Inflation

U.S. retail gasoline prices (AAA regular) averaged $4.54 in July vs $4.93 in June … that’s an 8% drop in a key July headline CPI input. We expect the YoY headline CPI and PCE price indices to fall from June’s respective 9.1% and 6.8% levels and believe this is already priced into the rate structure. The less volatile June core inflation measures were 5.9% for CPI and 4.8% for PCE … we do not expect that core inflation eased in July. The recent uptrend in core inflation looks increasingly entrenched and likely to continue amid higher shelter, services, and labor cost components which will likely refocus markets back to how far away inflation is from the Fed’s desired 2% inflation goal. These concerns should dominate this month even if the job market shows mild signs of cooling. July CPI will not be released until August 10^th while the PCE price index is a month-end (Aug 26) data point.

In the meantime, for borrowers, flexibility in interest expense is critical. Who is helping you avoid the potholes that lie ahead?

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