Rekindling Rate Cut Dreams

What You Missed

The past week offered little macroeconomic news, which shifted the financial market’s attention to mostly second-tier data and events. Notably, an increase in jobless claims and consumer concerns about job security suggested a potential weakening of the job market. This, coupled with the ongoing limited access to bank credit for businesses, could indicate a slowdown in the economy in the coming months. However, bond markets remained steady, with bond yields maintaining a sideways movement throughout the week. As for the coming week, that’s another story, with a chock-full calendar of first-tier data and events, centering on the latest read on inflation.

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Running the Numbers: Rates Rangebound in a Sleepy Week

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Bond yields were relatively flat throughout the week due to a mostly blank data calendar; however, the market’s reaction to negative growth news was on full display when yields fell after a small increase in US jobless claims and news that consumer confidence hit a six-month low, as the consumer struggles with high interest rates and high costs for the daily staples of life. For the busy week ahead, expect most of the rate moves to show up in the short-end, e.g., the 2-year Treasury yield. As for the timing of the first rate cut, Fed Funds futures markets are forecasting a 55% probability of such in December 2024 at the soonest.

For the week:

Where will SOFR be a year from now? 3-month (CME) Term SOFR, a valuable gauge for the true cost of interest rate hedging, held steady at 5.32%. The implied yield on the 3-month SOFR futures contract 1-year forward (June ‘25), an estimate of where markets expect 3-month Term SOFR – and by extension, hedging costs – to be a year from now, rose a modest five basis points week-over-week to 4.45%, reflecting the quiet week for events and data.

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 in early 2025. The forward curve projects that 1-month Term SOFR will steadily decline from here on out, eventually bottoming out near 3.78% in March 2028, up one basis point from this time last week.

Where is the 10-year Treasury yield headed? The 10-year Treasury yield forward curve implies that the yield will bottom out at 4.38% in January 2025, then stage a slow and steady sequential rise. The chart looks like the 10-year moves sharply higher, but the range is narrow.

While the forward curve for SOFR and Treasury yields isn’t a forecast – it’s proven to be a horrible predictor historically – it does give one a peak at the market’s current thinking.

When will rate cap costs decline? Rate volatility, a vital driver of the cost of option-based interest rate hedges like rate caps, continued its downward trend and is approaching a two-month low. Rate cap costs continue to hover 25-30% below their peaks and will likely continue their downward path as the long road toward the Fed’s first rate cut gets closer.

Are you curious about what a rate cap costs? Check out our rate cap calculator. The calculator is a valuable tool for providing 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 at 415-510-2100 for indicative pricing based upon the specific economics.

Elsewhere, equities rose sharply during the week, approaching record levels amid signs of an upswing in Europe and downshifting growth in the US, which reduced the odds of overheating. The price of a barrel of West Texas Intermediate crude oil rose $0.40 from this time last week to $78.90 as the US dollar traded flat and Gold strengthened.

An uptick in Jobless Claims Imply a Softer Jobs Market, or Do They?

The number of initial claims for unemployment insurance for the week ending May 4 increased to 231k on a seasonally adjusted basis, higher than the consensus forecast of 212k. While that sounds like a big jump, remember that jobless claims data is released every week, is volatile, subject to great revisions, and hasn’t proven to be an accurate indicator of the health of the overall jobs market. We tend to look at the four-week moving average of jobless claims to smooth out weekly volatility and get a clearer picture of the overall trend, which, for now, is one of strength.

Nevertheless, it’s fun to peel the onion. New York and California experienced the largest increases in unadjusted initial claims, with New York seeing a rise of 10.2k and California with a 4.2k increase. California’s rise in claims could be due to the increase in the minimum wage to $16 per hour, which became effective in January of this year, but frankly, it’s too soon to tell.

Bottom line: Last week’s jump in jobless claims implies a rise in layoffs, and when combined with last month’s weaker-than-expected jobs report and an uptick in the unemployment rate, could be forecasting rougher times for the jobs market ahead. However, one week’s worth of data certainly doesn’t make a trend, thus it remains uncertain whether this will result in a sustained rise that would prompt the Fed to consider cutting interest rates sooner or if it is simply a temporary adjustment influenced by seasonal factors. If the unemployment rate increases to 4.0% within the next two months – it’s 3.9% now – the Fed will have more reason to cut rates sooner than markets expect. Until then, we’re eyeing the release of the next jobs report on June 7th .

Consumer Sentiment at a Six-Month Low

According to the latest University of Michigan survey, consumer sentiment declined due to concerns about inflation, a negative outlook for the job market, and the expectation of higher-for-longer interest rates. The index gauges the level of positivity or negativity that consumers have towards the general state of the economy and their own financial situation. Consumers’ perceptions of their financial well-being, the current state of the economy, and the outlook for future economic growth directly impacts their spending and saving habits.

The headline consumer confidence index dropped to 67.4 from April’s final reading of 77.2. This was below the consensus expectation of 76.2. The expectation index experienced a decline to 66.5 (compared to 76.0), while consumers’ evaluation of their current conditions decreased to 68.8 (compared to the previous 79.0).

This news adds to a string of negative readings this year, with the survey results now sitting at a six-month low. With consumer spending driving roughly 75% of all US economic activity, persistent news like this is never good over the long run. As consumer stress increases, downside risks for the economy are also growing. We’ll see if it continues.

Will April’s weak jobs report + higher jobless claims + weak consumer sentiment all conspire to drive the Fed to cut interest rates soon? Probably not. The Fed must see the icing on the cake – clear signs that inflation is sustainably in retreat – before pulling the trigger on rate cuts. At best, we’re seeing signs that the economy is finally starting to feel the lagged effects of the 5.25% in rate hikes the Fed has bestowed upon us. We’ll need to see more signs of that pain in the jobs market before the Fed gets serious about rate cuts. Until then, we suspect they’re on hold until the fall.

Banks Maintain a Tight Grip on the Credit Purse Strings

According to the Fed’s latest Senior Loan Officer Opinion Survey (SLOOS), many banks continue to be tight in their business and household lending standards. Requirements for commercial real estate loans have become more stringent, while standards have tightened for credit card, auto, and other consumer loans. as a result, it may become more challenging for consumers to depend on credit to sustain their spending.

Our take: The Fed had this latest SLOOS survey in hand during their last policy meeting on May 1st, likely contributing to Fed Chair Powell’s more cautious tone during the post-meeting news conference.

However, it appears that banks are becoming less strict in their lending practices for most types of loans – with the exception of commercial real estate (CRE), where increased spreads over costs of funds, lower maximum loan sizes and loan-to-value ratios, and shorter periods of interest-only payments can be seen – indicating that annual overall loan growth, excluding CRE,  may increase. That’s the exact opposite of what the Fed wants to see and implies that the Fed’s pivot toward rate cuts last December and Chair Powell’s remarks on May 1st  – which implied the Fed is leaning toward rate cuts – were errors that resulted in the Fed easing up on its tightening measures prematurely.

What to Watch: Inflation Data Front and Center

Inflation has been the primary factor influencing the direction of interest rates this year, with almost half of the biggest daily moves in the 10-year Treasury yield occurring on days when inflation data was released. With the latest reading of the Consumer Price Index (CPI) set for release this Wednesday, this week will be no exception.

This time, the CPI data will test the current downward trend in Treasury bond yields. Yields retreated from year-to-date highs late last month after Fed Chair Powell dismissed concerns about the potential for interest rate hikes. The retreat gained speed after the Labor Department reported a slowdown in job growth, pulling yields down sharply from last month’s peaks. The dynamic has heightened the importance of this week’s inflation data, which has the potential to either prolong the downward trend in yields or label it as yet another failed attempt at a turnaround.

We’re expecting a 0.25% rise in April core CPI, slightly below the consensus of 0.3%. This would result in a year-over-year rate of 3.61%, just above the consensus of 3.6%. April headline CPI will likely rose 0.35% in April, slightly lower than the consensus of 0.4%. This would result in a year-over-year rate of 3.42%, slightly higher than the consensus of 3.4%. We also suspect that inflation will remain well above the Fed’s 2% target through 2024, keeping pressure on the Fed to keep interest rates high.

Zooming out for a longer look down the road, Fed Chair Powell has mentioned two potential paths toward the first interest rate cut: 1)  A big fall in inflation pressures (unlikely anytime soon, as this week’s CPI data will show), regardless of the state of the jobs market, or 2)  A sudden weakening of the jobs market (more likely than #1, but still low probability anytime soon), regardless of the state of inflation. This week’s data will help determine which of the two paths we’re on.

While everyone and their dog is salivating over this week’s CPI data, the Fed really cares about the core PCE Deflator, set for release on May 31, as it provides a broader and more consistent measure of inflation. The core PCE deflator has been running hotter than the CPI of late and, when combined with a solid jobs market, has given the Fed confidence to keep rates higher for longer.

Other data set for release this week will lend insight into how hot the core PCE deflator will be, specifically Tuesday’s Producer Price Index (PPI), which measures financial services and insurance inflation, among other things. In April, stock prices dropped. With financial services composing over 7% of the core PCE deflator, Tuesday’s PPI will provide a peek into whether the gauge will show high levels of inflation or not and, ultimately, if the data justifies the Fed moving closer to rate cuts.

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