Smaller Hikes Right Around the Corner

What You Missed

Yields across the maturity spectrum fell steadily over the course of a holiday shortened week, as key economic data on jobs and inflation painted a picture of a respectably strong economy amid an improving inflation outlook. While the economic reports were well-received by the markets, and should be encouraging to the Fed, current inflation levels are still nowhere near where the FOMC wants them to be. This scenario tells us that the Fed will likely hike rates at least two more times – 0.25% in February and another 0.25% in March – then hold rates steady through the rest of the year before eventually cutting rates in early 2024.

For the week, the 2, 5, 10 and 30-year US Treasury yields fell a respective 12, 14, 18 and 15 bps. Overall, the continued drop in yields reflects the financial market’s belief that short-term rates are indeed going higher, but the US economy won’t be able to sustain higher rates for long.

Elsewhere, global equities were higher than when we last reported just before Christmas, while the price of a barrel of West Texas Intermediate crude oil fell $4.50 to $74.75 from a week ago as the US dollar weakened, and Gold strengthened. The US 2-year vs. 10-year Treasury yield spread, a widely watched barometer of the likelihood of a looming recession, held near its most inverted level since the early 1980’s at -0.70%.

Hedging Costs Ease Further but Remain High

3-month (CME) Term SOFR, a useful gauge of hedging costs due to its liquidity, continued its slow but steady ascent, rising 6 basis points to an all-time high of 4.66%, in concert with short-term Treasury yields. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘24) fell 19 basis points from this time last week, also in concert with the fall in Treasury yields, to 4.20%. The SOFR futures market continues to imply that markets expect 3-month SOFR will peak in late spring 2023 – along with the Fed Funds rate – near 5.16%, 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, reversed its recent ascent, falling to levels last seen in early December, dragging rate cap prices lower with it.

US jobs market robust but wage gains slow

In what is always the single most important economic data point for interest rates, last Friday’s jobs report for December showed that headline nonfarm payrolls increased by 223k in December (vs. 256k in November), slightly higher than the 200k expected. The prior two-months data was revised down to a net -28k. The household survey of jobs painted an even stronger picture. Employment rose 717k (vs. -66k prior), exceeding the increase of 439k in the labor force. That pushed the unemployment rate down to 3.5% (vs. a revised 3.6% prior).

Monthly average hourly earnings (aka wages) growth in December, a key predictor of how inflation may move in the future, mellowed to 0.3%, matching expectations. The prior month’s wage gauge showed an alarming 0.6% jump in wage growth, which rattled the Fed, has now been revised away, as hourly earnings in November only increased by 0.4%, about the same pace as most of 2022.

Our take: On whole, the data gave conflicting signals; on one hand, America’s job creation engine remained strong; on the other, growth in wages cooled, muffling the inflation alarm bells that so-rattled the Fed last month.

The unexpected drop in the unemployment rate from 3.7% to 3.5% was certainly not welcomed by the Fed, but it will take comfort in a rise in the labor force participation rate to 62.3% from 62.1% as well as in slowing wage growth.

Like we’ve said for months now, if you want to know what the Fed will do next, watch the jobs market. Last week’s data showed that the jobs market isn’t cooling as fast as the Fed hopes, and wage growth, despite its recent slowing, implies that inflation will remain well higher than the Fed’s target for months to come. Expect two more quarter-point hikes from the Fed – 0.25% in February and another 0.25% in March – and no rate cuts until early 2024. Such a move implies a peak Fed Funds rate of 5%, with the floating rates we all know and love, 1-month LIBOR and SOFR, peaking at a similar level.

Services sector tanked in December, confirming Fed hikes are biting

The ISM Services Index plunged 6.9 points to 49.6 in December, from a robust reading of 56.5 in November, now below the key 50 threshold, implying a mild contraction in activity. The signal of cooling demand for services was confirmed in price declines, providing an encouraging sign on services inflation.

Our take: For months, there has been a wide divergence between two measures of services inflation – S&P Global’s services sector purchasing managers’ index and the Institute for Supply Management’s measure, blurring the inflation picture. That divergence has now narrowed markedly and shows Fed rate hikes starting to bite. Having already seen prices for goods peak, it’s now clear that the Fed is making real progress in cooling demand for services. However, the Fed will need to see a consistent trend of lower inflation in core services prices – excluding those related to housing – before cutting rates.

FOMC minutes show a pivot is off the table – for now

Markets have been interpreting any hint of slowing inflation as a signal that the Fed will soon stop hiking interest rates and begin lowering them shortly thereafter. However, the minutes of the December FOMC meeting, which were made public last Wednesday, indicate that the Fed isn’t contemplating doing so. In fact, the meeting minutes showed that none of the members of the Fed’s rate-setting committee anticipate rate cuts in 2023.

Although the price of goods, and now services, are falling, the Fed is seemingly nevertheless concerned that a strong jobs market, and by extension, its upward pressure on wages, could derail its inflation fighting progress. The International Monetary Fund urged the central bank to continue raising interest rates last Thursday, stating that the US has not yet turned the corner on inflation.

What to Watch – Latest Inflation Gauge Will Help Build the Case for a Pause

As we enter a bright and shiny new year, inflation, and its ultimate impact on interest rates, is still the dominant factor driving markets these days.

The slew of important economic data released last week, most notably December’s jobs report and the ISM services print, adds to evidence showing inflation pressures continue to cool, but are doing so too slowly for the Fed to deviate from its rating hiking path anytime soon. If the inflation cooling trend continues however, it could just be the evidence the Fed needs for it to pause its hiking campaign, likely sometime this Spring.

December’s Consumer Price Index (CPI – Thursday), which we expect to show a continued softening of inflation pressures, will solidify our belief. The steady decline in energy prices has also probably helped to sharply reduce consumer’s near-term inflation expectations (University of Michigan Consumer Sentiment Index – Friday).

Big Picture – Rates Rangebound

In the meantime, the China-driven slump in commodity prices, easing supply constraints, discounts to clear excess business inventories, and an ongoing downturn in interest-rate sensitive sectors, like real estate, will all serve to grind inflation lower, and relegate yields to defined ranges, particularly the ten-year Treasury yield, which we expect to trade in a 3.5 – 4% range over the next few months. This rangebound rate dynamic will spillover onto reduced rate volatility in the coming months, as the end of the Fed’s hiking cycle comes into view, helping to reduce the cost of rate caps and other option-linked interest rate hedges.

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