Resist the Rate Cut Hype

What You Missed

A worse-than-expected read of the health of the jobs market spurred interest rate markets to pull forward their expectations for the Fed’s first rate cut, now projecting a 60% probability for a 0.25% rate cut in December. Elsewhere, despite proof that inflation pressures remain uncomfortably high, Fed Chair Jerome Powell surprised with a less aggressive tone at the May FOMC meeting. Our take? One month’s worth of weak jobs data doesn’t make a trend; thus, we’re still doubtful we’ll see a rate cut anytime soon.

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Running the Numbers: Rates Lower on Renewed Hopes for Rate Cuts

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Last week, the interest rate markets underwent a significant shift in their expectations for US interest rates, triggered by comments from Fed Chair Powell, which seemed to rule out the possibility rate hikes. Data also indicated a weakening jobs market. The impact of these developments was most pronounced in the short end of the curve, with the 2 and 5-year Treasury yields experiencing the largest moves.

While short-term yields are heavily dependent on monetary policy expectations, there is more that goes into determining the level of long-term yields, e.g. the 10-year, including expectations for future funding needs by the US government. Those funding needs are expected to be huge, with the government continuing to spend like a drunken sailor on the likes of defense, coping with an aging population, attempting to mitigate and prepare for climate change, and positioning itself as a leader in AI. All this will likely push the fiscal deficit to the neighborhood of $1.6 trillion by year’s end, and $1.8 trillion late next year. All that puts upward pressure on long-term Treasury yields, with the 10-yar Treasury yields likely to stay well above 4.00% over the coming quarters.

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, fell twenty-six basis points week-over-week to 4.36%, reflecting financial markets’ renewed view that any interest rate cuts are off the table and that the Fed will cut interest rates at least once this year.

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 3.77% in January 2028, down twenty-four basis points from this time last week.

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.

Where is the 10-year Treasury yield headed? The 10-year Treasury yield forward curve implies that the yield will bottom out at 4.44% in December 2025, then stage a slow and steady sequential rise.

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 sequential declines that began in mid-April. 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 were higher on the week as fears over the potential for the Fed to shift gears toward rate hikes vanished. The price of a barrel of West Texas Intermediate crude oil fell $3.64 from this time last week to $78.98 as the US dollar weakened and Gold traded flat.

Fed Vanquishes Any Possibility of Rate Hikes

As expected, the Fed maintained its stance at the recent monetary policy meeting, refraining from making any changes in the Fed Funds rate for the sixth consecutive time. The Fed Funds rate remains at 5.50% (upper-bound), with the central bank citing a lack of significant progress in its efforts to bring inflation down to its 2% target.

What caught everyone off guard was Fed Chair Powell’s post-meeting press conference. Despite the persistence of high inflation pressures, Powell refrained from adopting a more aggressive stance toward combating inflation. This suggests that Powell and the Fed’s committee members are confident that inflation pressures will naturally decrease over the year without the need for additional Fed action, such as rate hikes. Furthermore, Powell hinted that the Fed is open to reducing interest rates if the economy requires it, even with the presidential election looming in November.

Bottom line: It seems that the Fed is relying too heavily on positive supply-side factors to reduce inflation naturally, which may prove to be less effective in bringing it down to the Fed’s 2% target.

Is the Fed Really Apolitical?

During election years, we often ask whether the Fed is truly apolitical. The answer is a resounding YES, and it’s crucial that it remains so. The economic consequences of a politically influenced Fed can be severe in the long run. To play the devil’s advocate, let’s delve into a couple of potential outcomes of a political Fed:

  1. Inflation Risks: The Fed’s independence is vital in ensuring impartiality when making monetary policy decisions. If it were influenced by politics, it could potentially prioritize policies that stimulate short-term economic growth instead of focusing on long-term economic stability, resulting in increased volatility and uncertainty in financial markets. That’s a disaster for the performance of US stock and bond markets and the US dollar.
  2. Reduced Credibility: Believe it or not, the Fed is the world’s central bank, with many other economies in the developed world adopting the Fed’s policies in their own economies. Given that the US Dollar is the world’s reserve currency and is expected to be so for many decades to come, the Fed’s credibility is paramount in maintaining the status quo and allowing the Federal government to continue to borrow at relatively low interest rates. If the Fed is perceived as an extension of the current government, it may undermine its credibility and potentially hinder its ability to manage the economy effectively.

If you’re hoping the Fed will favor a certain political candidate or party, be careful what you ask for. Such an outcome won’t end well.

Are High Interest Rates Finally Impacting the Jobs Market? We’re Not Convinced.

In what is always the single most impactful piece of economic data on interest rates, headline nonfarm payrolls increased by 175k in April (vs. an upwardly revised 315k in March), lower than the consensus estimate of 240k. The prior two months’ jobs reports were revised lower by a net  -22k.

Job growth was concentrated in industries that tend to perform well during economic downturns, such as healthcare. Additionally, there was increased hiring in sectors that experienced a decline in the previous year, like transportation and warehousing. Local government, a sector known for its sensitivity to economic cycles, experienced a substantial decline in hiring, dropping from 51k in March to zero in April.

The household survey showed a weaker performance, with employment only increasing by 25k (versus March’s 498k increase). Modified to align with the definition of headline nonfarm payrolls, the household increase amounted to 563k (versus 352k previously). Are you curious about why there are two monthly employment measures? Here’s why 

The unemployment rate rose to 3.86% (compared to 3.83% previously), exceeding the average prediction of 3.8%. Average hourly earnings, a.k.a. wages, increased by a modest 0.2%, implying that recent increases in the minimum wage have yet to show their face in the overall wage data.

In a separate but related set of economic data—the Employment Cost Index—wages jumped 1.2% in Q1 (vs 0.9% prior), showing that inflationary pressures continue. Productivity gains slowed, suggesting worker efficiency isn’t increasing despite increased compensation. Such dynamics pressure firms to either pass on higher costs to consumers (higher inflation) or lay off workers.

Bottom line: While a weaker jobs market is a required catalyst for the Fed to consider interest rate cuts seriously, it’s important to remember that one month’s worth of weak data does not make a trend. With the financial news media and many economists falling all over themselves to declare that we’ve finally turned the corner toward a weak jobs market – and, by extension, a near-term interest rate cut – we suspect it’s too early to draw that conclusion.

At best, the April jobs report does imply a change in trend, but it will take at least another weak jobs report – or two – for the Fed to seriously consider the timing of the first rate cut. Pile on stubbornly high inflation, continued growth in wages, and ongoing strength in housing, and any rational person would conclude that we’ve got a long road ahead of high interest rates.  Until then, the Fed will continue to follow its path of data dependence – scrutinizing every piece of economic data on jobs and inflation – before coming to any real conclusion.

As we’ve stated in prior Straight to Smart newsletters, Fed Chair Powell’s pivot toward rate cuts last December helped boost the US economy this year while keeping inflation pressures high. As such, to get inflation back on a declining path, Powell may need to adopt a more aggressive approach, at least publicly. He clearly passed on the opportunity at last week’s post-meeting press conference. We’ll see if his stance changes in future media appearances.

Powell’s lack of concern over this year’s inflation readings stems from his optimism that favorable supply-side factors will restore inflation to the Fed’s 2% target without significant job losses. If this scenario, called “immaculate deflation,” came to fruition, as Powell seems to believe it will, it would be a miracle of monetary policy.

What to Watch – More Signals that Lending Standards Remain Tight

We’ll all take a break this week after last week’s Fed meeting, and jobs report double whammy.

The only data release of note is Monday’s Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS). The quarterly survey of eighty large domestic banks is designed to provide valuable insights into banks’ lending practices and conditions and covers changes in the standards and terms of banks’ lending and the state of business and household demand for loans.

We suspect the surveys will show that bank’s lending standards remain tight, particularly for consumer loans and commercial and industrial loans. Consumer delinquencies and defaults are likely increasing, leading banks to exercise even more caution, potentially serving as a cautionary signal for the Fed.

Outside of the skinny data calendar, Fed officials will be out in force in speeches and media appearances, hammering home the message that rate hikes are off the table. The Fed already sees interest rates as restrictive, but the key question now is just how restrictive and whether the Fed feels that its neutral rate of interest – the level of the Fed Funds rate that neither stimulates nor suppresses economic activity – has risen and by how much. Such insight sheds light on where long-term interest rates are headed.

DL at NAFOA

Derivative Logic’s Native American Gaming Team just returned from the Spring Native American Financial Officers Association (NAFOA) at the Seminole Hard Rock Hotel & Casino – Hollywood, Florida.  It was a well attended conference and we want to express our gratitude to NAFOA for organizing a great and informative conference.  We had a surprise guest stop by our booth, fortunately he didn’t stay too long.

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