Recession Hallmarks are Building
What You Missed
Data showing a surprising retreat in inflation led many to speculate that it’s on a fast-track to return to the Fed’s 2% target, driven there by a broad cooling in economic activity. The debate now is whether 1) America’s economy will achieve the much hoped-for soft-landing scenario, where the economy narrowly avoids a recession as inflation pressures evaporate amid a mild weakening in the jobs market and an “on hold” Fed , or 2) If the economy will slowly but surely drift into a full-blown recession, where employment suffers more markedly, prompting the Fed to cut interest rates sooner rather than later. Both scenarios suggest rate cuts are coming, possibly as soon as March. We’re betting on #2, as evidence of a near-term recession builds.
Are you wondering where are rates headed in 2024? Plan to watch our Q1 2024 Interest Rate Outlook livestream on Wednesday, December 13th.
In the meantime, click here to view our Q4 Outlook from October. How did we do?
Running the Numbers: Rates Lower on Shaky Data
Looking for live market rates and historical rate data? Check out our Interest Rate Dashboard.
Steep declines in Treasury yields across the curve indicate that bond markets believe the Fed’s rate hiking cycle is over. The topic of discussion now shifts to the timing and magnitude of the first rate cut. Expectations from the market currently point to at least 125 basis points of easing in 2024, paving the way for lower yields in the near-term.
For the week:
2-year Treasury yield: down 26 basis points to 4.62%
5-year Treasury yield: down 22 basis points to 4.19%
10-year Treasury yield: down 14 basis points to 4.25%
30-year Treasury yield: down 12 basis points to 4.43%
1-month Term SOFR: down 1 basis points to 5.34%
Where will SOFR be a year from now? 3-month (CME) Term SOFR, a useful gauge of hedging costs, fell three basis points to 5.36%. The implied yield on the 3-month SOFR futures contract 1-year forward (December ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, fell a whopping thirty-seven basis points week-over-week, to 4.04%, hammering home the market view that the Fed is done hiking and will have engaged in a handful rate cuts by this time next year.
How much higher will SOFR rise? 1-month SOFR, via the SOFR forward curve, implies that one-month SOFR has already peaked near 5.34%, and will decline precipitously over the next year as the Fed eventually cuts interest rates several times throughout 2024.
Will rate cap costs ever decline? Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, rose week over week, reflecting the large moves in Treasury yields. Yes, lower Treasury yields help to drag the cost of rate caps lower, but these cost declines are blunted by higher rate volatility. Curious what a rate cap costs? Check out our rate cap calculator.
Elsewhere, equities were modestly firmer on the week. The price of a barrel of West Texas Intermediate crude oil rose about $1.50 from last week to $73.54, as the US dollar traded flat, and Gold strengthened to a record high, typically a harbinger for a tough economic future.
Is inflation Fast-Tracking to the Fed’s 2% Target?
The Fed’s successful slaying of the inflation dragon continues to be front and center, as it dictates the future direction of interest rates. Last week’s release of the October personal income and spending report showed that monthly headline personal consumption expenditures (PCE) inflation – a measure of the changes in prices and spending on goods and services by consumers – was flat (versus 0.4% previously), less than the consensus estimate of 0.1%. The decline was mainly due to lower energy prices.
Core PCE, what the Fed really cares about as it excludes volatile food and energy prices, also declined, decelerating to 0.2% month on month (vs. 0.3% prior) and 3.5% (vs. 3.7%) on an annual basis. On a one-, three- and 6-month annualized basis, core PCE inflation rose 2.0% (vs. 3.8% prior) 2.4% (vs. 2.4% prior), and 2.5% (vs. 2.8% prior) all close to the Fed’s 2% target.
Finally, “supercore” PCE inflation, the Fed’s preferred price metric which accounts for core inflation but excludes inflation in housing rents, dropped sharply to 0.1% in October (from 0.4% prior). It collapsed mainly due to price declines in the lodging and financial services industries, two sectors that are regarded as volatile and therefore unlikely to see a sustained decline.
Why you should care: Fed Chair Powell has said repeatedly that the Fed will keep rates high until inflation is seen meeting the Fed’s 2% target. If core PCE inflation continues its pace of declines, year-over-year core inflation will end 2023 at 3.4%, below the Fed’s 3.7% estimate in its most recent Summary of Economic Projections. If measured on a six-month annualized basis, core PCE inflation would fall to 2.2% by the end of 2024, very close to the Fed’s 2% target.
Our take: The PCE data justifies recent comments from Fed officials – especially Chair Powell – that interest rates are already high enough to smother inflation, and that another rate hike isn’t needed. On the flip side, the PCE data also shows that its declines are due to a broad slowing of economic activity, raising the probability of a recession.
Fed’s Beige Book Forecasts a Dicey Future
As we said last week, the tell-tale signals of a looming economic downturn, notably persistent unemployment, declining real personal incomes, sluggish credit demand, a prolonged manufacturing slump, companies cutting inventory to boost sales, and eroding consumer confidence are all flashing red. Additionally, at times of economic transition, the quality of economic data typically deteriorates. There are signs of such in the monthly jobs report, job openings, and housing starts, which have all been consistently revised lower month over month throughout this year. Simultaneously, history has shown that the data which indicates soft landings have misled policymakers leading into previous recessions, and why the Fed and Wall Street tend to recognize downturns months after they begin.
Fed officials are particularly interested in anecdotes during times of uncertainty. In last week’s release of November’s Beige Book, a compilation of data from the 12 Fed district banks detailing the economic conditions in their respective regional economies, the tone was the most pessimistic since 2020. According to the survey, layoffs were more common, two-thirds of districts saw flat to declining economic activity, and many districts reported weaker demand.
Our take: The combination of the PCE data and humdrum Beige Book, which paint a worse picture than we expected, tell us that the probability of a formal recession has risen, and why Fed officials have recently implied that they’re done hiking and that the Fed will pivot to rate cuts next year. The billion-dollar question now? When will the first rate cut show up?
50% Chance of a Rate Cut in Q1 2024
This week, Fed officials adopted a more conciliatory tone, tiptoeing toward addressing the topic that we’ve all been waiting for: When will the central bank start cutting?
Encouraged by the declining trend in inflation and data indicating a slowing economy, a long list of Fed policymakers – six of whom will sit on the rate setting committee next year – said in recent days that they were comfortable with holding rates steady at their next rate-setting meeting on December 13th. While falling short of explicitly discussing the timing of rate cuts, the closest they’ve come is to say that the cuts will come – eventually – if inflation continues to fall. At the time of this writing, financial markets, via the Fed Funds futures markets, are pricing in a total of five, 0.25% rate cuts over the course of next year, with the first beginning in March.
Our take: We suspect that the classic signs of a recession began to surface back in October, and that it’s likely that we’re already in a shallow recession right now. If our timing is right, the unemployment rate should rise steadily in 2024 and reach 5% by the end of the year, a characteristic of a mild recession historically. The Fed will have sufficient knowledge about the recession by March 2024 to be confident enough to pull the trigger on its first rate cut. However, since it implies that rate cuts will arrive five months after the downturn most likely started, they will come too late to prevent one.
An alternative, lower-probability scenario is one where the Fed achieves an economic soft-landing but does so by cutting interest rates earlier than March and more aggressively, prompted by a more significant economic shock than anticipated.
What to Watch: Jobs Report to Support Recession Narrative
Our long-held belief that the risk of recession is higher than most believe is now supported by the most recent economic data. Before the last couple of weeks, data showed that the jobs market, investment, and spending were cooling only slowly. But now, data is showing a more sudden deceleration. As an example, the Atlanta Fed GDPNow (the most real-time measurement for GDP growth available) has dropped suddenly, from 2.1% to just 1.2% at the end of last week.
The negative trend is likely to continue in the upcoming week’s data. The rate of people voluntarily quitting their jobs (JOLTS, Tuesday) is trending downward, and as fewer people leave their jobs, it logically takes longer for others to find employment. This is a common occurrence when a sustained increase in unemployment is around the corner. Adding to sour mood, the Institute of Supply Management survey for services – which reflects the business conditions and activity in services, the largest sector of the US economy – (Tuesday) is likely to show stagnant or decreasing employment in the sector.
Elsewhere, we anticipate that the unemployment rate for November (via the always important jobs report – Friday) rose to 4.0%, which would set off a number of unemployment-based recession rules that have an excellent record of predicting a recession, like the Sahm rule. Expect the jobs report to show that 145k in new jobs were created in November, but that the prior jobs data, for October, will be revised down, just like most other past jobs reports this year, by 120k or so as the conflicting forces of the resolution of the UAW strike and a general erosion of the jobs picture whipsaw the data.
What Smart Borrowers Are Considering Now: Step-up Interest Rate Caps
Interest Rate Caps typically have one strike rate which, if breached, pays the hedger the difference between the strike rate and the higher interest rate. Think of the strike as the trigger that prompts an insurance policy to pay once a certain interest rate level is breached. The hedger buys an interest rate cap at a pre-determined strike, term, and notional principal amount to protect against rising interest rates associated with a floating rate loan tied to an index such as SOFR. The cost, or premium, to purchase a cap is based on several inputs: Hedge amount, strike, risk-free interest rate, time, and volatility (the unknown variable).
Interest rate caps are more expensive in a highly volatile environment. Thus, borrowers who purchased caps when interest rates and volatility levels were at all-time lows are now confronting higher rate cap costs to extend existing caps or purchase a new cap in conjunction with a loan extension or refinance.
There are numerous cap structuring strategies to reduce the cost of a cap. Any hedging structure that reduces a cap’s cost means accepting some higher level of interest rate risk. However, the reduced cost may more than offset the additional exposure to floating interest rates.
Think of a “Step-Up” as a flight of stairs where the steps represent a series of increasing strike levels. The borrower, or hedger, starts with a lower strike cap on the first step; then, and after a pre-determined period, steps up to a higher strike. They can even take another step with a strike higher than the second step, and so on.
Let’s assume the borrower wants to buy a rate cap, and/or the lender is requiring one, at a 4.50% strike on a notional amount of $20MM for 3 years. The estimated cost of the cap is $350,000. What would be the approximate cost of the cap if the strike in the first year was 4.50%, then steps up to 5.00% for the second year, and 5.50% in the third year? Under this “step-up” strike scenario, the cost would be $270,000; savings of $80,000.
There are multiple reasons a step-up cap makes sense. Lenders often require an interest rate cap on short-term bridge financing. These loans often have a high credit spread due to the associated risk with the asset. The borrower and lender expect the asset to generate more income over time and increase in value. The borrower, upon maturity of the loan, can choose to refinance at a lower credit spread or sell the asset.
From an credit underwriter’s perspective, the first year is the riskiest, and generally, the strike is determined based upon expectations of the asset performing in years one and two. The lender would prefer a low strike for the entire term; but is a low strike too much protection? In our experience, we’ve rarely seen a term sheet that states the rate cap strike can increase after every year. However, we have been successful many times in negotiating a step-up cap structure on our client’s behalf.
Assume the forward curve is expecting SOFR to not reset above 5.00% over the next three years. If the market (i.e. forward curve) is wrong – hint: it always is – and there is a shift to higher rates that exceed 5.00% in the second year, what would be the impact on the bottom line? Yes, in such a scenario Interest expense would increase by around $100k for the year but keep mind the “step-up” cap structure brought an initial savings of $80k.
Generally, higher interest rates mean the economy is performing well and inflation is rising. Certain assets perform well in an elevated inflationary environment thereby acting as a natural hedge.
Lenders want your business, and they are willing to accommodate hedge structures that make sense for both parties. However, the lender isn’t going to help a borrower structure a hedge that saves the borrower money, nor do they have the expertise and resources to find creative hedging solutions for their borrowers. That is why a borrower should seek the advice of an independent derivatives advisor with capital market experience.
To summarize the analysis of a “step-up” strike structure:
- Lower upfront premium.
- Structured to mitigate risk that matches the growth and expected future income of the asset.
- Flexibility that reduces the risk of prepayment penalties associated with a fixed rate loan.
- Higher strikes in the later years may trigger covenants if the asset isn’t performing as expected.
- Opportunity cost. Hedger might have been better off buying the lower strike cap.
While there is no slam dunk rate cap structure that works for every deal, there are situations where a step-up cap structure makes sense. Are you facing a loan extension along with the high cost of extending a rate cap while also enjoying a high-performing asset? A step-up rate cap structure may be right for you. Give us a call at 415-510-2100 to discuss your situation.