The Elephant in the Room

What You Missed

Everyone received some goodies from the much-anticipated Fed meeting last Wednesday, as the 2024 dot plot was revised to project three interest rate cuts and the expected level of rates further out was revised up. But while everyone was busy counting the dots and parsing Fed Chair Jerome Powell’s language in the post-meeting press conference, almost everyone missed the elephant in the room:  the fact that monetary policy overall remains very loose despite over 500 basis points of rate hikes. This tells us that any near-term Fed rate cut would probably be a mistake.

Running the Numbers: Rates Lower Amid New Hopes for  Rate Cuts

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Despite one of the fastest rate-hiking cycles ever, monetary policy is still incredibly loose. The fed funds and SOFR futures curves are steepening, and pressure is on to maintain the “higher for longer” narrative amid upward pressure on Treasury yields as the Fed reluctantly eases back on its December pivot. When we stand back and consider all the monetary policy that has been implemented during this cycle, we can see that conditions have loosened significantly rather than tightened.

A case in point: Below is a chart featuring an index we like to watch, the Goldman Sachs Financial Conditions index (in white), that charts a weighted average of Fed Funds, Treasury bond yields, corporate credit spreads, equity prices and a trade-weighted exchange rate. What is it telling us? That financial conditions are looser now than they were at the start of the year (yellow bubble), placing the logic of any near-term Fed rate cut into question. The index is joined in the chart below by the US 10-year Treasry yield (blue), 1-month Term SOFR (red) and the Fed Funds rate (pink). For more on this topic, check out our Q2 Interest Rate Outlook.

Bond investors don’t care.  They are cautiously reloading bets that burned them only a few weeks ago as they look to the prospect that the Fed and its major global peers will begin cutting interest rates as soon as June.

They’ve been playing the game all year and losing. Previous bets that the world’s major central banks would quickly cut interest rates blew up in their face as the Fed and its global counterparts continued their laser focus on above-target inflation and robust demand. Are bond investors wrong to expect near-term rate cuts? You decide. Global central banks are certainly helping to juice the narrative after the unexpected rate cut by Switzerland’s central bank last week and a constant stream of dovish statements made by the Bank of England and the European Central Bank. And oh yeah, don’t forget Fed Chair Powell’s rate-cut-speak last week.

For the week:

Where will SOFR be a year from now? 3-month (CME) Term SOFR, a more useful gauge of hedging costs than 1-month Term SOFR, fell two basis points to 5.31%. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘25), an estimate of where markets expect 3-month Term SOFR – and by extension, hedging costs –  to be a year from now, fell 13 basis points week-over-week, to 4.24%, reflecting hopes that the Fed’s dot plot – that implied three rate cuts this year – will come to fruition.

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 several times throughout 2024. The forward curve projects that 1-month Term SOFR will steadily decline from here on out, eventually bottoming out near 3.61% in February 2028.

Where is the 10-year Treasury yield headed? The 10-year Treasury yield forward curve implies that the yield will bottom out at 4.04% in October 2024 – it’s sitting at 4.22% right now, and posted a 4.99% 12-month high back in October –  then stage a slow and steady sequential rise. We suspect that a 10-year Treasury at 4% – assuming the Fed is ultimately successful in bringing inflation down to its 2% target – will be Fed Chair Powell’s long-term legacy.

When will rate cap costs decline? Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, fell once again week over week, now sitting firmly at a two-year low. Rate cap costs continue to hover 25-30% below their peaks and will likely continue their downward path as the probability of the first Fed rate hike gets closer. Curious what a rate cap costs? Check out our rate cap calculator.

Elsewhere, equities were positive on the week in response to dovish pivots by many global central banks. The price of a barrel of West Texas Intermediate crude oil fell $1.86 from this time last week to $80.87, as the US dollar and Gold both strengthened.

Same as It Ever Was: Why the Fed Meeting Didn’t Change Much

The Fed kept rates steady for the fifth consecutive time – at 5.25-5.50% – during last week’s meeting, and there was only one minor adjustment to the policy statement: Officials now merely stated that “job gains have remained strong,” as opposed to the prior assessment back in January that stated, “moderated since early last year but remain strong.”

Via its updated dot plot and accompanying Summary of Economic Projections, Fed officials still see 75 basis points of rate cuts this year, with the Fed Funds rate ending 2024 at 4.6% (it’s 5.5% now), unchanged from the last time the Fed revised its forecasts back in December.  Crucially, however, the median participant updated the rate projections further out, putting the Fed Funds rate in 2025 at 3.9% (up from 3.6% prior) and in 2026 at 3.1% (up from 2.9%). That implies 70 basis points of rate cuts in 2025, down from the 100 bps that were projected in the previous SEP back in December 2023, and 80 bps of cuts in 2026, up from 70 basis points prior.

While it’s fun to parse every decimal point of the dot plot, remember not to draw too many conclusions from it as the Fed officials often go out of their way to tell the world that it’s not trying to imply a narrative by publishing it, combined with the fact that the dot plot has proven to be a horrible predictor, in hindsight, of what the Fed actually does. If you’re into this, check out this dated but still useful guide to misinterpreting the Fed dot plot (paywall). If that’s not enough for you, learn why some believe the dot plot should be scrapped altogether.

Moving on to the Fed Chair’s post-meeting press conference, Powell gave a somewhat dovish speech, emphasizing that the committee didn’t take any cues from the recent hot Consumer Price Index (CPI) inflation data, and made sure to exclude one of his signature dovish statements: that the Fed could start cutting interest rates even with inflation still running “well above” 2%. For perspective,  the last reading of the CPI – for February – had it running at 3.2%. Fed funds futures markets – where interest rate predictors wager their beliefs – are now pretty much lined up with the Fed in pricing slightly more than three 0.25% cuts this year.

Bottom line: Higher for longer is here to stay for awhile. Most changes in the updated Summary of Economic Projections indicate that the Fed is gradually shifting toward the belief that the Fed’s neutral Fed Funds rate – that is, the level of Fed Funds that neither stimulates nor suppresses economic activity – may end up being higher than the Fed’s December 2023 assessment. That means that policy rates must therefore stay higher for longer, despite the dot plot’s expectation of 75 basis points of cuts this year. That tells us that, while the Fed will cut rates at least a couple of times this year, those rate cuts won’t show up until the back half of the year, with the first showing up no sooner than July. Ultimately, last week’s meeting and projections don’t change a whole lot; the Fed’s policy prognosis remains highly data dependent.

What to Watch: Inflation Coming in Hot

Fed Chair Jerome Powell delivered a relatively dovish speech during the Fed’s post-meeting news conference last week. However, what really caught our attention was his ambiguous answer when asked if the Fed could lower interest rates as early as May or June. According to Powell, cuts could come earlier than later in the event of “unexpected” negative events in-between meetings or an “unexpected” deterioration in the jobs market.

While he was purposefully short on details, Powell may have been referring to the possibility of an unforeseen, widespread crimp in lending appetite or an unanticipated and sustained jump in unemployment. Knowing that the labor and credit markets tend to be the areas where the long and erratic lags of monetary policy manifest themselves last, it appears that the 5.25% in rate hikes over the last two years has had minimal impact on those sectors of the economy – so far. Given the resilient economy we’re all living in – it has defied expectations of recession for several quarters now – it’s likely that the Fed believes that the economy is simply strong enough to withstand higher interest rates, but the Fed is also smart enough to give themselves an out in case they’re wrong.

For now, the Fed will continue its focus on inflation, and expects that this Friday’s reading of February’s core Personal Consumptions Expenditures (PCE) data – a measure of consumer spending – will be more subdued than the recent high CPI print (3.2% in February). The Fed’s preferred measure of inflation, the 12-month change in core PCE inflation, is still projected to drop to 2.5% or less by June or possibly earlier.

Chair Powell is aware of the negative risks presented by the jobs and credit markets but probably isn’t as concerned about the recent strong CPI prints as the markets are. That’s the kind of worry that seeps into the recesses of his consciousness regarding “unexpected” events.

Other key events this week are Tuesday’s release of the durable goods report and a slew of speaking events from Fed officials. They’ll be hammering home the message that the Fed remains vigilent in its inflation fight, but is ready to cut interest rates should financial conditions warrant it.

Strategy Corner: Accreting Interest Rate Caps

We’ve noticed a shift in lender required interest rate caps to accommodate an accreting or amortizing credit facility.   Most term sheets state that the loan amount is the notional required for the interest rate cap, and many lenders have traditionally required a borrower to purchase an expensive interest rate cap with a notional amount equal to the fully committed loan amount. Times are changing.  We recently priced an amortizing cap, and the cost was 50% less expensive than a rate cap whose notional amount was equal to the fully drawn loan amount. We asked this lender, “Why the change after so many years?” Their answer? “To be more competitive”.

Are you in the midst of negotiating a construction loan that requires an interest rate hedge? Know your options. Contact us at 415-510-2100 or to learn what may be available to you.

To learn more, give us a call or schedule a Derivatives 101 session.

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