Stop Dreaming of Rate Cuts
Click below to listen to this week’s edition of Straight to Smart
What You Missed
Amid a dearth of economic data releases, last week’s focus in interest rate markets was on survey findings and Federal reserve comments. Now that banking system risks are increasingly seen as contained, it all percolated to a now widely held view that the Fed will hike another 25 basis points at its next policy meeting on May 3rd. What’s still up for debate is how quickly thereafter the Fed will cut interest rates in response to an economic recession. We’re still in the camp that the Fed will engage in a long pause – keeping interest rates higher for longer than most expect – after May’s hike, and likely won’t cut interest rates until late this year at soonest amid ever-present inflation pressures and a mild-recession that begins in the second half of 2023.
In the meantime, crosscurrents abound. Traders have increased their bets that the Fed will hike interest rates in both May AND June, putting the central bank’s eagerly anticipated pause into question. The reason? The economy has so far proven to be more durable than expected, and it appears that inflation isn’t falling fast enough toward the Fed’s 2% target for its liking. Throw in building anxiety that a political standoff over the debt ceiling in Washington may not be addressed until the country is on the verge of defaulting. Also clouding the economic outlook is the possibility that banks could reduce lending to boost investor confidence. Although there is less concern about a full-fledged banking crisis now than there was last month, seemingly tightening credit will eventually hinder economic growth. This slow moving but steadily developing credit crunch is clouding the outlook for the Fed and interest rates.
Running the Numbers: Rates and Volatility Fall, Reducing Hedging Costs
In a quiet week, rates drifted lower, searching for a catalyst amid a short slate of economic data releases and Fed speeches. For the week, the 2, 5, 10 and 30-year Treasury yields fell 4, 8, 7 and 7 basis points, respectively. The fall in short-term yields released some pressure in the 2s-10s yield spread, a widely watched barometer of looming recession, to -62 basis points, well off its most inverted level (-108) since the 1980’s, briefly seen a few weeks ago. Swap rates on 3-, 5-, and 10- year maturities are each now at least ~54 basis points below their Q1 cycle highs, meaning fixed rate financing, if available, remains on discount.
3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, made up lost ground to trade at 5.07%, shy of its all-time high near 5.12% hit back on March 10th. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, fell 4 basis points week over week, to 4.01%. Swaps markets are pricing around 45 basis points in rate cuts before the end of the year, implying a credit contraction or recession will start to bite over the summer.
The SOFR futures market, and the forward curve it projects to the world, implies that 3-month SOFR will peak at 5.09% sometime in June, and expects it to decline over the next year as the Fed eventually eases.
Elsewhere, global equities were flat on the week. The price of a barrel of West Texas Intermediate crude oil fell $4.62 to $77.94., while the US Dollar and gold both weakened slightly.
**Borrrowers: Have you received a notice, like this one from your rate cap bank asking you to contact them to address the LIBOR transition? Contact us before you respond, as making the wrong decision will cost you money.**
Borrowers Beware: The LIBOR to SOFR Transition Is Not Your Friend
We’re being flooded with calls and emails from borrowers who were recently informed by their lender that their LIBOR-based, floating rate loan would be converting to a new floating rate index, SOFR. Don’t be fooled, there is nothing standard or routine about transitioning the index in your loan or transitioning the index in your rate cap or interest rate swap.
Confused or uncertain about how the transition will impact you? Give us a call, 415 510-2100, to help guide you through it with as little damage to your bottom line as possible. Make no mistake, making the wrong decision will cost you money.
Regional Fed Banks strike cautious tone
In a report that’s mostly ignored by markets, last week’s release of the most recent Beige Book gathered more interest than usual amid a light data calendar and the lingering bumps and bruises suffered by many in the banking industry.
What’s the Beige Book you ask? Published eight times a year by the Fed, its a compilation of anecdotal information on current economic conditions as viewed by each regional Federal Reserve bank. Each of the 12 regional Fed banks interviews regional bankers, economists, business leaders, and other regional players. The report is made public two weeks before every Fed policy meeting.
In the most recent Beige Book, the first following Silicon Valley Bank’s failure, regional Fed banks adopted a cautious stance, evidencing slower lending volumes and loan demand. Numerous districts reported tighter lending standards, even though there was no immediate, significant shift in the economic circumstances.
Our take: As use of the foreign repo facility – which provides an emergency source of US Dollars for foreign central banks and other institutions that hold accounts with the Fed – decreased to $20 billion from a peak of $60 billion last month, banks’ overall borrowing from the Fed’s emergency facilities effectively reached a plateau (+$4.4 billion week over week). From a macroeconomic viewpoint, we continue to see banking risk as being corralled, with banks’ propensity to lend being influenced more by the fundamentals and margins of its borrowing companies rather than by any concerns about Silicon Bank inspired contagion. We expect the trend to continue.
Debt ceiling debate coming into focus
Just one month ago, financial markets were expecting the Fed to cut interest rates as early as June, with the Fed Funds rate falling well below 4% by the end of the year (it’s 5% now). Fast forward to today, those same markets expect Fed Funds at 4.60% at year’s end, a significant change of sentiment in just a few weeks. What gives? Forecasting interest rates is a tough game, especially given the current crosscurrents of geo-political turmoil, fiscal policy and the US debt limit, aka the “debt ceiling”.
While you can read the details elsewhere, Republicans in Congress and President Biden are at odds over raising the debt ceiling, the legislatively mandated limit on how much the US can borrow. The US has already reached its $31.4 trillion borrowing limit, and the US Treasury is now utilizing accounting tricks to pay the government’s debts, an effort that will only bridge America’s funding gap through June.
On a day-to-day basis, the influence of government policy – and debt ceiling negotiations – on financial markets is small. As such, we usually ignore the political theatrics, where politicians always seem to come to an agreement to kick the can down the road at the eleventh hour. However, this time around, it seems as if the debt ceiling drama will soon impact interest rates, and hence, we are giving it more attention.
To avoid being involved in the drama around the debt ceiling, investors are pouring money into ultrashort-term Treasury bills. One-month T-bill prices have increased due to a surge in demand, which has caused the yield to drop from 4.675% at the end of March to 3.313% today. A record-breaking incentive to lend to the government for a few more months is the 5.105% interest on bills that mature in three months.
If you are paying attention, the June 15 due date for corporate tax payments looms large; if the US Treasury can hold out until then in bridging the country’s funding gap, it will get some breathing room. Until then, enjoy the political show.
What to Watch: Inflation Data Won’t Support Calls for Rate Cuts
The street is struggling to figure out exactly what’s going on with the world as an important week of data and events approaches. There doesn’t seem to be any doubt that the economy and the global financial system are being impacted by higher interest rates globally, but figuring out how much of a headwind they are is a challenge. Data on tap this week will help sort it out.
The PCE Deflator and the Employment Cost Index (ECI), two of the Fed’s favorite price and wage gauges, will offer a test of whether recent inflation data supports current market expectations of a coming pause in Fed rate hikes, and most importantly, the ~50 basis-points of rate cuts expected by markets by the end of the year. While a pause may be supported by this week’s data, the expected rate cuts will not.
Pretty much everyone expects that services inflation, Fed Chair Powell’s favored “supercore” inflation gauge (core services excluding housing) and ECI all rose last month. All three have hovered in a 4-6% range over the last six months, even as other prices of goods and energy have fallen, hence the Fed’s focus on them. Layer on the expected spike in this Friday’s print of the University of Michigan consumer sentiment survey for April, which measures consumer’s inflation expectations for the future, and you’ve got ample evidense that rate cuts from the Fed may be far off in the distance.
When taken together, these inflation gauges imply that a peak fed funds rate of 5.25% (25 basis points higher than it is now) may not be high enough to smother core inflation that’s hovering at a rate of 4% – 6%. Regardless, recent comments from Fed officials imply a consensus among the Fed members that its cycle of tightening is about to come to an end, with a strong indication of one more 25-bp boost at the May meeting.
Other data on tap, such as those on personal income (Friday), GDP and pending home sales (both Thursday), could support the minority view within the Fed that the banking system and economy are resilient enough to shoulder additional rate hikes beyond May.
Strategy Corner: Fixed Rates are Lower than Floating, is Borrowing Fixed Really an Easy Decision?
Fixed rates look attractive right now, given that SOFR is below term rates. Looks like a no brainer to borrow at a fixed interest rate over a floating one. A slam dunk, or is it? History tells us otherwise. In situations where short-term rates are higher than long-term interest rates, financial markets, via the forward curve, tend to underestimate how much the Fed will lower rates, and it turns out to be 50 basis-points or 100 beyond what is expected.
Should history repeat itself, and Fed does eventually cut rates faster and more than markets expect, suddenly that fixed rate you locked in 6, 9 or 12 months ago does not look so great in hindsight.
If you’re looking at refinancing at a fixed rate, consider:
1) Will the Fed lower rates more than current market expectations?
2) Will the Fed raise rates higher than expectations?
The answer may seem a simple yes or no, but there is no simple answer. Mistakes in financing strategy can be costly down the road, and using an advisor with significant market experience is crucial to guide you through uncharted waters. View an independent study on the topic: Interest rate risk: fixed or floating? Curious? Reach out to us.
Current Select Interest Rates:
Rate Cap & Swap Pricing:
10-year US Treasury Yield:
Source for all: Bloomberg Professional