Resist the Rate Cut Hype – Part 3

What You Missed

The latest reading on inflation was lower than expected for the second consecutive month. While encouraging, the still-high prices for goods and services we all consume every day helped drive consumer sentiment to a seven-month low. Amid the patchwork of mixed data,  the Fed signaled that it expects just one rate cut this year, a conclusion we’ve expected for weeks now.  Markets remain skeptical, pricing in two, 0.25% rate cuts in 2024. The billion-dollar question now: Is it enough to push the Fed to cut sooner rather than later? We think not.

Our Interest Rate Hedging 101 on-site training is now approved for Continuing Legal Education (“CLE”) credits in many states, notably California, New York, and Texas.  Want to give your legal team a solid understanding of macroeconomics, interest rates and the best practices of hedging?

Give us a call at 415-510-2100 or Click here to arrange a session and receive CLE credit. It’s free.

Running the Numbers: Rates Notch Lower on Encouraging Inflation Data

Looking for live market rates and historical interest rate data? Check out our Interest Rate Dashboard.

Investors are learning a valuable lesson from the US bond market, highlighting the realities of the new financial landscape: Economic data is more important than anything the Fed says. A case in point is last week’s release of better-than-expected inflation data, which spurred Treasury yields lower in one of their biggest one-week moves of the year, seemingly ignoring signals from the Fed that it plans to keep rates higher for longer. The takeaway? Markets will stay volatile as the interest-rate outlook is continuously reevaluated with the arrival of key, sentiment-moving economic data.

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, traded flat at 5.34%. 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 26 basis points week-over-week to 4.26%, reflecting lower Treasury yields and renewed hopes for more than one rate cut 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, eventually bottoming out near 3.44% in May 2028, down about twenty basis points from this time last week.

Where is the 10-year Treasury yield headed? The 10-year Treasury forward yield curve implies the yield will bottom out at 4.10% in June 2025 and then stage a slow and steady sequential rise. With all the US Treasury’s debt issuance on tap in the coming quarters and a seemingly resolute Fed, it’s tough to imagine a 10-year Treasury yield sustainably below 4.20%.

While the forward curves for SOFR and Treasury yields aren’t forecasts – they’ve proven to be a horrible predictor historically – they 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, spiked to a one-week high. Rate cap costs continue to hover 25-30% below their peaks and will likely continue their slow, downward path as the road toward the Fed’s first rate cut gets shorter.

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 traded near fresh record-high levels on the back of encouraging inflation data. A barrel of West Texas Intermediate crude oil rose $0.44 to $78.36 as the US Dollar and Gold strengthened.

Encouraging Inflation Data Fired Up Rate Cut Hopes Anew

Yes, we had a Fed meeting last week, but the latest readings on inflation stole the show.

May’s soft reading of inflation at the consumer level – via the Consumer Price Index (CPI) – was a positive sign for the Fed, indicating that it is indeed making progress in its ongoing inflation fight.

Headline and core CPI both came in lower than expected. Headline CPI was flat (vs. 0.3% prior), corresponding to a year-over-year change of 3.3% (vs. 3.4% prior). Core CPI inflation – which strips out the volatile energy and food components and is more important for the outlook on interest rates –  rose 0.2% monthly (vs. 0.3% prior), and 3.4% year over year (vs. 3.6% prior).

Layer on an unexpected decline in inflation pressures at the producer level  – via the Producer Price Index (PPI) – and it’s easy, perhaps too easy, to conclude that the disinflation momentum is building.

The PPI decreased by 0.2% in May compared to the previous month, lower than economists had estimated. A decline in the cost of diesel fuel, commercial electric power, and jet fuel drove the PPI lower month over month. Zooming out, however, the PPI increased by 2.2% year over year.

Taken together, the CPI and PPI data imply that the core PCE deflator – the Fed’s favorite inflation gauge and the one that influences it most in setting interest rates – fell to 2.6% in May (versus April’s 2.8%). If that forecast is accurate (we won’t know until its official release on June 28th), it would be the lowest reading since March 2021. The fly in the rose’? A core PCE deflator at 2.8% is still far higher than the Fed’s 2% target. For some perspective, the core PCE was 2.9% at the start of 2024, 4.3% in June 2023, and 4.9% at the start of 2023. That’s progress, no doubt, but it also shows that the “last mile” of the Fed’s inflation fight is proving to be a long one.

Bottom line: The latest reads of CPI and PPI have resurrected hopes of a September Fed rate cut, and justifiably so. However, due to the mixed bag of economic data of late – with some indicators signaling stubbornly high inflation and others less so, both overlayed with ongoing signs of a strong jobs market and respectable wage growth,  the Fed will likely need a string of such encouraging inflation data to build the case of a September cut. Until then, a core PCE above the Fed’s 2% target – combined with a solid jobs market and solid economic growth – doesn’t suggest any urgency for the Fed to cut. And as for the Fed’s 2% inflation target, who came up with that number anyway? Here’s your answer.

Keep in mind that the Fed likely needs a large burden of proof that inflation is sustainably in retreat before seriously considering a cut. Think about it this way: It takes just one high CPI to wreck the notion of disinflation, but a string of monthly readings to prove that inflation is truly inretreat before the Fed can get comfortable with the idea that price increases are on track to converge to its target. As such, the Fed will take its time. It’s a dynamic that will keep rates across the curve supported at least through the fall.

Fed Meeting Conclusion: Rates Will be Higher for Longer

While everyone expected the Fed to stand pat on interest rates last week, as they chose to do, the surprise was, according to the Fed, just how long rates need to stay high to bring inflation down to the Fed’s 2% target.

This was implied via the Fed’s revision to its quarterly Statement of Economic Projections, specifically, the dot plot (page 4), which implies the average Fed member only expects 25 basis points of rate cuts this year. That’s down from 75 bps in the March dot plot and lower than the financial markets’ expectation for two cuts this year, or 50 bps in all. The change was likely inspired by the recent string of strong job reports.

Alongside the dot plot revisions, members of the Federal Reserve also adjusted their inflation forecast. The revised core PCE inflation for 2024 was increased to 2.8%, in contrast to the previous estimate of 2.6%. Further out on the forecast horizon, Fed members saw core PCE inflation at 2.3% in 2025 (vs. 2.2% prior), with inflation not returning to the Fed’s 2% target until 2026.

All told, the revisions imply that the Fed believes that keeping rates higher for a longer period is necessary to bring inflation back to its 2% target and that the current level of interest rates isn’t as successful at constraining economic activity as it had previously thought.

We agree with the Fed’s assessment and have been saying this for weeks, as the resilient economy and weighted averages of 105 measures of financial activity imply that financial conditions are looser – not tighter –  than most believe. Take a look for yourself via the Fed’s National Financial Conditions Index. Financial markets hold a contrasting view, now applying a 65% probability of a 0.25% cut in September 2024, followed by an 81% probably of another 0.25% cut in December. The problem with markets is that they have been consistently wrong in guessing the timing and degree of rate cuts. They’ve pumped up rate cut expectations several times this year, only to backtrack to a “higher for longer” consensus as inflation proved to be stubbornly high. It’s no different this time around.

Three more CPI reports are scheduled before the September Fed meeting, which should provide the Fed with increased confidence that they’re slowly but surely winning the inflation fight. On the flip side, with wages growing faster than the inflation rate, consumers will largely maintain their spending patterns, keeping uncomfortable inflation pressures alive. Add in a weakening but still robust jobs market, and the Fed will have zero reasons to cut more than once this year, likely in December. What could derail our rate cut expectations? With inflation expected to stay stubbornly above the Fed’s target at through the next couple of quarters, the catalyst must come from a weakening jobs market. So far,

What to Watch: Consumer’s Resilience in Focus

After the triple-whammy of CPI, PPI, and the Fed meeting last week, the week ahead will be quieter, with mostly second-tier data and events on the calendar.

There has been a heated debate among economists this year regarding why so many are down on the US economy. There are plenty of explanations to go around. Some dismiss the gloom by referencing positive indicators such as healthy household balance sheets, GDP growth, retail sales, and a still-robust jobs market. Others cite the two-tiered consumer: one that’s benefitting from rising home prices and stock markets, and the other that’s just scratching by, feeling the impact of inflation much more than the first.

Data on retail sales for May (Tues.) is likely to reveal only modest increases, which should help to debunk the idea that all consumers are financially secure but unaware of it. The flip side of the softer CPI data discussed above is that it also implies that consumers – who alone are responsible for ~70% of all US economic activity – may be tightening their belts, as prices have fallen for a wide range of non-essential goods and services.

Looking ahead, US households have reached new heights in their investment in stocks and bonds, but their ownership of real assets remains at average levels. This dynamic is pushing equity valuations higher, raising concerns about what economic future we all face in the event of an equity market correction.

Strategy Corner: Customized Rate Cap Structures Yield Great Savings to Borrowers

We are seeing new bridge borrowing with required caps at strikes that are more in line with the market.  Many bridge facilities have accreting/amortizing schedules, which should be considered when structuring the cap.  Don’t fall asleep on it; a borrower can achieve substantial savings by using that same accreting/amortizing schedule with the rate cap.  We’ve helped numerous clients work with the lender to accommodate such.  A “step-up” cap is another reducing cap cost strategy.  For example, the first 2 years of the cap is struck at 5.00%, and the last year is 6.00%.   The last year of the cap is the most expensive, hence the higher, 6% strike brings down the overall cost of the cap dramatically.  Curious? Call us to discuss your unique situation.

Click to check out our Market Data pages and Calculators

Interest Rate Dashboard
Forward Curves
Interest Rate Cap Calculator
Defeasance Calculator
Yield Maintenance Calculator