Separating Signal From Noise

Are you attending the NMHC in Las Vegas this week? So is Derivative Logic. We’ll be speaking with clients 1:1 about: rate cap extensions (ideas to reduce the pain), what’s happening with the yield curve, the LIBOR to SOFR transition (best not to go it alone), and questions about interest rate swaps. Is this a good time to fix?

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What You Missed

Yields across the maturity spectrum fell slightly, as markets struggled to filter out the noise from the signal of a strong-enough economy amid an improving inflation outlook. On first look, data showed that America’s economy grew briskly, but after stripping out volatile components, revealed a slowdown as  signs of seemingly ever-present inflation persisted. The Fed will downshift to a 25-basis-point hike at its meeting this week, while emphasizing that its hiking campaign is far from over.

For the week, the 2, 5, 10 and 30-year US Treasury yields fell a respective 3, 1, 1 and 6 basis points. Overall, the stagnation in yields, a continuation of their falling trend over the last few months, reflects the financial market’s belief that the Fed won’t be able to hike rates as much as it claims, and that the US economy won’t be able to handle higher rates for long, eventually tipping into a recession later this year.

Elsewhere, global equities rose from a week ago on the back of the headline economic growth data. The price of a barrel of West Texas Intermediate crude oil fell slightly to $80.10, as the US Dollar weakened, and Gold traded flat. The US 2-year vs. 10-year Treasury yield spread, a widely watched barometer of the likelihood of a looming recession, dipped once again toward the most inverted level since the early 1980s, to -0.70%.

Hedging Costs Ease Further but Remain High

3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, continued its steady ascent, rising two basis points in the week to 4.68%, an all-time high. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘24), a rough estimate on where rates will be a year from now, rose three basis points from this time last week, to 4.18%.

The SOFR futures market continues to imply that 3-month SOFR will peak in late spring – along with the Fed Funds rate – near 5.00% followed by a gradual decline over the next three years as the Fed eventually eases.  Finally, interest rate volatility, a key driver of the cost of rate caps and other option-linked interest rate hedges, continued its declining trend established in late December 2022, falling to levels last seen in June 2022. We expect rate volatility to continue to moderate, and rate cap costs continue to fall, as the end of the Fed’s rate hiking campaign inches closer into the spring.

Q4 Economic Growth Looks Good on the Surface, but the Devil is in the Details

Real Gross Domestic Product, the most comprehensive measure of US economic activity, increased by 2.9% in Q4, slightly down from 3.2% in Q3, but higher than the 2.6% expected. After removing volatile components like trade, inventory fluctuations, and government spending, growth in the economy looks to be much more subdued than the headline number suggests.

The US Conference Board’s Leading Economic Indicator index (LEI), a forward-looking measure of economic activity, fell 1% in December from the prior month and fell 7.4% year over year, worse than expected amid a weakening outlook for manufacturing, home builds and financial markets. Generally, when changes in LEI turn negative, it signals a downturn in economic conditions in the near term.

Our take: The economy surprised to the upside in the second half of 2022, although momentum is now proven to be slowing heading into 2023. The economy experienced strong growth in Q4 thanks to consumer spending on services, but the good news ends there. Two indicators of fundamental activity that exclude erratic factors like trade, inventory movements, and government spending revealed noticeably slower growth. On the bright side, a pickup in productivity growth is inspiring, especially after its considerable deterioration early last year. If it continues, it will help ease inflationary pressures over time, and get the Fed closer to ending its rate hiking cycle.

Now that Q4’s GDP data is in, America’s economy grew just 1% overall in 2022, a decrease from 5.7% in 2021, which was fueled largely by massive fiscal stimulus and a surge in economic re-openings. For perspective on how the data reconciles with the Fed’s thinking, a 0.5% growth print was predicted for 2022 in the Fed’s December Summary of Economic Projections.

The Fed’s Favorite Inflation Gauge Undershot its Expectations, or Did It?

The metric Fed Chair Jerome Powell says he watches closely for signs of durable inflation – the headline Personal Consumption Expenditure Deflator (PCE) – rose 0.1% in December, the same as in November, but was higher than the 0% expected. The “core” PCE rose 0.3% in December versus 0.2% in the month prior, corresponding to a 4.4% increase on a year-over-year basis, matching the consensus forecast.

Why it matters: The Q4 2021 versus Q4 2022 changes for both the headline and core PCE – at 5.5% and 4.7%, respectively – are lower than the Fed’s latest median projections, published in December. That’s the first time PCE, again what Fed Chair Powell claims is his favorite gauge of inflation, undershot the Fed’s forecast for 2022. The data nearly guarantees that the Fed will downshift to a 25-basis point hike at this week’s policy meeting.

The fly in the pinot noir? Inflation in the price of services is indeed improving, but probably isn’t improving fast enough to cause the Fed to cease rate hikes anytime soon nor stop short of hiking the Fed Funds rate to at least 5% (it’s 4.50% now).  At 0.4%, the latest core services inflation reading for December remained strong, unchanged from the previous month. The measure has been averaging 5% annual growth over the past one, three, and six months.

Going further, Fed Chair Powell has identified PCE, excluding housing rents, as the indicator to watch for signals of real proof that inflation is moderating. Unfortunately, just the opposite is happening. It increased by 0.3% in December, the same as in November, equating to an annualized growth rate of 4.1%. When viewed on an annualized 6-month basis, PCE – ex housing rents has been steady at about 4% for the past 12 months, in comparison to an average of just 2% before the pandemic.

Bottom line: The PCE, not the media-loved Consumer Price Index (CPI), is the Fed’s preferred inflation gauge, and it isn’t showing the same convincing signs of declining inflation that markets are betting on in their expectations of rate cuts this year. PCE’s ultra-core component is still persistently high, despite the headline PCE print being the latest in a succession of soft  inflation data. At the same time, real economic growth is slowing. It’s a combination that will prompt the Fed to acknowledge that monetary policy is succeeding in slowly smothering inflation, but its work is probably far from done. The dynamic tells us that we’ll see at least another 50-basis points in rate hikes before the Fed is through and calls any rate cuts this year into question.

What to Watch – The Fed’s Dilemma

It’s a crazy busy week this week, with  important data and events on tap throughout the week.

The Fed will be in a pickle during this Wednesday’s policy meeting. On the one hand, headline inflation data has come in softer than anticipated, and indicators of the pace of consumer’s spending activity over the past month have slowed as has economic growth; on the other hand, financial conditions have eased as traders anticipate the Fed will soon turn to rate cuts. Sure, recent economic data justifies a downshift in the size and pace of rate hikes, but the Fed is more likely to remain firmly on the hiking path as inflation still remains uncomfortably above its target.

It’s unlikely that the Fed will surprise us this week. Chair Powell’s risk management style is to go slow when faced with uncertainty. And the uncertainty is building amid blooming downside risks to economic activity (Case-Shiller Home Price Index & consumer confidence, both Tuesday; ISM manufacturing index, Wednesday; ISM services index, Friday); while upside risks to inflation, via robust wages, are slowly evaporating (Employment Cost Index, Tuesday). After all, he continues to hold great optimism for a soft economic landing (ADP Employment and JOLTS index, Wednesday; jobs report, Friday).

We expect the Fed to hike Fed Funds by 25-basis points to 4.75% (upper-bound), while the Fed Chair will stress that he needs to see more convincing signals that inflation is indeed moderating, particularly in the jobs market, via higher unemployment and flatlining or falling wages. Recent numbers on jobless claims, which have been below 200k for two straight weeks, indicate that the jobs market is still tight, putting a floor under consumer spending and inflation. It implies that the jobs market must weaken substantially for the Fed to entertain a pause in its hiking campaign, let alone rate cuts.

Interest Rate Swaps: Myths and Misconceptions

We’ve been pulled into many discussions between floating rate borrowers and bank lenders of late, where an interest rate swap is on the table as a possible vehicle for hedging rate risk. Given our decades of experience in trading swaps on the trading floors of large, money center banks, we’re experts at understanding the nuances and complexities of the swaps market.  During our countless discussions with clients from a myriad of industries, and financial and non-financial staff, there are certain beliefs about derivatives that we consider myths or misconceptions. Considering a swap to hedge rate risk? Here’s high-level run down of commonly misunderstood aspects that if ignored, will cost you money:

1: “The bank is betting against me.”

2: “When unwinding a swap, the negative termination value isn’t really a loss to the bank.”

3: “The Bank is earning more in interest because I have to write a check every month on the swap.”

4: “The ISDA and Schedule to the Master Agreement are non-negotiable.”

5: “Derivatives are risky.”

6: “Swap rates are transparent; anyone can find them.”

7: “A Pay-Fixed Swap is the best method to hedge floating rate debt.”

8: “My Bank is giving me a competitive rate.”

9: “I’m concerned if I hire an Independent Derivative Advisor, I may lose some negotiating power.”

10: “Why pay an Independent Derivative Advisor when the Bank can offer the same service.”

To learn more about the pros and cons of interest rate swaps, sign-up for our Derivatives 101 seminar.  It’s free. Email us us@derivativelogic.com

Current Select Interest Rates:

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Source for all: Bloomberg Professional