Resist the Rate Cut Hype – Part 2

What You Missed

Financial markets held a white-knuckle death grip on evidence that could imply that an interest rate cut is around the corner. It’s just another re-run of an episode we’ve all watched several times this year that has always ended in disappointment.  Here’s how it goes: A couple of economic data points – on their surface – imply that inflation is slowly moving closer to the Fed’s 2% target. Traders and the financial news media take the bait, the former adjusting their positions to prep for a rate cut and the latter broadcasting from the rooftops that a rate cut is right around the corner. A few weeks go by, a handful of contrary pieces of data are released, and traders and the media slowly but surely backtrack, with their rate cut hopes quashed.

The moral of the story? A mixed bag of economic data can be interpreted as conducive to a near-term interest rate cut. Still, since the data doesn’t inarguably lead to that conclusion, the data can just as easily lead to a totally different one. The problem is that the murky picture the data paints just isn’t definitive enough for the Fed, and because of this, will keep the Fed on the rate-cutting sidelines longer than most expect.

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Running the Numbers: Rates Lower on Resurrected Rate Cut Hopes

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Bond yields moved lower through the week on the back of key inflation data, which painted a mixed picture and called into question the success of the Fed’s inflation fight. Financial markets only focused on the positive aspects of the data, latching hard onto any signal that could be interpreted as a catalyst of interest rate cuts.

Elsewhere, markets are suddenly facing tumult in the leadership of two major powers in the Middle East. The death of Iran’s president and the health of Saudi Arabia’s king are the types of events that feel like they should matter, and over the long run, they may, but for now, the impact of each seems muted as trading in oil markets remains calm. As for the timing of the first rate cut, Fed Funds futures markets are forecasting a 50% probability of a September cut, and a 60.9% probability of the same in December.

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 a modest 1.5 basis points week-over-week to 4.45%, reflecting the view of a downward trend for interest rates.

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 3.68% in April 2028, down a few basis points 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 4.34% in January 2025 and then stage a slow and steady sequential rise. Ultimately, a 1-year Treasury yield near 4% will be Fed Chair Powell’s legacy.

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.  Cap costs can vary widely  – as much as 40% – when considering changes in the notional schedule or “step-up” strike structures.

Elsewhere, equities rose to or near record highs 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 $0.54 from this time last week to $78.70 as the US dollar weakened and Gold strengthened to a new record high.

The Latest Read on Inflation Implies a Near-term Rate Cut. Or does it?

The headline Consumer Price Index (CPI) for April – a measure of the change in prices paid by consumers – decreased slightly to 0.31% (versus March’s 0.38%). The year-over-year change also moderated to 3.4% (versus the previous 3.5%).

The “core” CPI, which excludes the volatile food and energy components, also logged a noticeable slowdown in April, dropping to 0.29% (versus March’s 0.36%). The core gauge fell to 3.6% (versus 3.8% previously) year-over-year. Based on the Fed’s metrics used to assess inflation’s momentum, the core CPI increased by 3.6%, 4.1%, and 4.0% on a one-, three-, and six-month annualized basis, respectively. These figures are slightly lower compared to the March readings of 4.4%, 4.5%, and 3.9%.

Also released last week was the latest read on inflation from the other side of the coin: the wholesale level via the Producer Price Index (PPI). PPI rose in April by 0.5%, more than projected, and was mainly driven by services (versus goods). Compared to a year ago, the PPI experienced its highest increase since April 2023.

The CPI and PPI data feed into the inflation gauge the Fed really cares about in setting interest rates, the core PCE Deflator, which is set for release on May 31. Given April’s CPI and PPI, the core-PCE Deflator is expected to increase (not what the Fed wants to see) by ~0.25%. While that’s slightly lower than the 0.26%-0.49% range seen in the first three months of the year and corresponds to a year-over-year core PCE change of 2.8%, in our opinion, it’s still at a level that is just too high for the Fed to seriously consider cutting interest rates, especially given the still strong jobs market.

Bottom line?  April’s CPI report showed positive progress, but the PPI showed the opposite. Both contribute to a core-PCE Deflator that’s probably too high for the Fed to seriously consider cutting interest rates anytime soon. Regardless, many in the markets and the financial news media will do all they can to keep their rate-cut dreams alive, but we just don’t see reasons to cut just yet.

As an aside, the gap between CPI and PPI continues to broaden and is a proxy for corporate profit margins. After a rise and fall through the pandemic, they are consistently rising again. Corporate profits are positioned to be one of the main drivers of persistent consumer inflation in this rate cycle. This begs the question: Are calming inflation pressures and a rising stock market – driven by higher corporate profits, mutually exclusive? Is “greed-flation” really a thing? We’ll have an answer for you next week.

Consumers are Tightening their Purse Strings

Retail sales stalled in April versus a downwardly revised 0.6% in March, below what most people expected. Consumers’ moderating savings and a slowing use of credit cards were to blame.

Amid stubbornly elevated inflation, consumers find it increasingly difficult to afford items that have become considerably more costly, mainly due to their limited additional income. This is just another signal that the “long and variable lags” emanating from the Fed’s 5.25% in rate hikes continue to show their impact.

What to Watch: Fed Minutes Offer Much-Needed Peek into the Fed’s Brain

April’s somewhat encouraging CPI report and disappointing retail sales somehow sparked renewed hope for rate cuts. Futures markets now project a 50% probability of a 0.25% cut in September 2024 and a 62% probability of a 0.25% cut in December 2024. In our opinion, that’s a very pollyannaish takeaway from mediocre economic data.

The 12-month change in inflation is still meaningfully higher than it was five months ago, following several months of upward surprises. Add declining retail sales and recent signals of slower economic growth, and we should probably put stagflation on the economic bingo card.

As we travel the country, we’re often asked whether stubbornly high inflation means that the Fed’s neutral rate of interest (“r-star”) – the level of the Fed Funds rate that neither suppresses nor stimulates economic activity – has increased. Or said another way, is there a high likelihood that interest rates will stay higher for much longer than most expect? Our answer? Probably. The current level of interest rates (Fed Funds at 5.50%) doesn’t seem high enough, on its own, to lower inflation to the Fed’s 2% target. Assuming inflation stays stubbornly high, we’ll need to see a rapidly cooling jobs market and slowing economic growth to get inflation moving sustainably lower. The Fed seems to disagree, and minutes from its May 1st policy meeting (set for release this Wednesday) may tell us why.

Outside of the Fed meeting minutes, durable goods orders, new and existing home sales, and the final read of consumer sentiment for May fill the week’s data calendar. Taken together, they will likely continue to paint a mixed economic picture, with no clear signal on the future direction of interest rates.  In the meantime, a parade of Fed officials are set to speak publicly this week, all projecting slightly different views of the economy and interest rates.

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