The Fed is a Tease

What You Missed

The events and data releases from last week all conspired to force markets to dash hopes – yet again – for any near-term interest rate cut, now surrendering to a higher-for-even-longer reality and a murky path forward for interest rate markets. The shift in sentiment highlights growing concerns that this week’s Fed monetary policy meeting, which concludes on Wednesday, could signal an even shallower easing cycle than hoped for, as the latest inflation and jobs market readings give the Fed zero reason to embark on a prolonged campaign of interest rate cuts anytime soon. For now, we’re still expecting the first rate cut this summer, likely in June or July.

Are you wondering where rates are headed in 2024? Watch our insightful and crisply presented Q2 2024 Interest Rate Outlook livestream on Friday, March 22nd, at 10 am PT / 1 pm ET.

You’ll quickly learn what’s moving the interest rates that are critical for you and your investments. And, you’ll be able to get questions answered by our interest rate experts, live!  Save the date in your business calendar today.

Running the Numbers: Rates Higher as Rate Cut Hopes Recalibrate

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Treasury yields have surged recently and are poised to reach new highs for the year as traders are delaying their plans for US monetary easing as data keeps pointing to persistent inflation. Interest rate swap markets are currently pricing in less than three quarter-point rate cuts this year. That’s a fraction of the six reductions that were factored in at the end of 2023 and less than the Fed’s median estimate from December. And the timing of the first rate cut? Many are no longer confident that it will happen in the first half of the year.

The change highlights growing concerns that this week’s Fed monetary policy meeting could signal an even shallower easing cycle. Furthermore, even though investors believe rates will eventually decline, recent trading activity in the options markets indicates that they are looking for protection against the risk of higher long-term yields and fewer rate cuts.

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, rose two basis points to 5.33%. 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, rose 26 basis points week-over-week, to 4.36%, reflecting the revised view that the jobs market is still-strong but softening, inflation pressures are persisting and that hopes for any near-term Fed interest rate cut are misplaced.

How much higher will SOFR rise? 1-month Term SOFR, via the SOFR forward curve, implies that one-month Term 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 3.70% in December 2027.

Where is the 10-year Treasury yield headed? The 10-year Treasury yield forward curve implies that the yield will bottom out at 4.14% in December 2024 – it’s sitting at 4.32% 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 getting 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 close to a two-year low. Rate cap costs continue to hover 25-30% below their peaks and will likely continue on their downward path as the probability of the first Fed rate hike gets closer in the back half of the year. Curious what a rate cap costs? Check out our rate cap calculator.

Elsewhere, equities were little changed on the week amid signs that progress toward central bank inflation targets is slowing globally. The price of a barrel of West Texas Intermediate crude oil rose $3.62 from this time last week to $81.19, as the US dollar strengthened and Gold weakened.

Falling Rents Are Tempering Inflation’s Rise

The headline and core consumer price index (CPI) for February, released last Tuesday, increased by 0.4% (compared to 0.3% in January). On a year-over-year basis, headline inflation increased to 3.2% (from 3.1% prior) and core inflation, which excludes the volatile food and energy components, decreased to 3.8% (from 3.9% prior). On one, three, and six-month annualized bases – metrics the Fed uses to gauge inflation’s momentum – core CPI rose 4.4%, 4.2%, and 3.9%, respectively (vs. corresponding December readings of 4.8%, 4.0%, and 3.6%). So as not to come to false conclusions, it’s always a good idea to peel back the onion a bit to determine where higher prices are showing up in the economy, specifically if the despised price increases are showing up in the cost of goods versus services, and why.

Let’s break it down. In a disturbing turn of events, core goods prices increased by 0.1% (vs. -0.3% prior) after eight consecutive months of stagnant or declining readings. However – and of particular interest to our commercial real estate readers – core services inflation decreased to 0.5% from 0.7% previously due to a slowdown in owners’ equivalent rent. Owners’ equivalent rents have a far greater weight in the CPI than primary, aka “asking” rents (27% vs. 8%).  Thus, the moderation in owners’ equivalent rents more than offset the increase in asking rents, even though asking rents rose more quickly at 0.5% (vs. 0.4% previously). Confused by the flavors of “rents” in the CPI? You’re not alone; this should clear it up for you.

Our take: CPI rents are mostly continuing their slow and steady descent from their peaks, kind of like your kid snowplowing down a long, meandering steep ski slope on their way to the warm ski hut. Since owners’ equivalent rent lags real-world, asking rents by a year or so and operate similarly to how the commercial real estate industry defines the in-place rent roll, they both must ultimately follow the same trajectory.

Zooming out to the bigger inflation picture, the slow but steady fall in owners’ equivalent rents over time will be less and less of a driver of overall inflation going forward. Thus, even if other components of the CPI re-accelerate, their impact on driving inflation higher will be blunted. That’s a good thing if you’re hoping for lower borrowing costs this year.

Taking it all together, the core CPI is now running higher than in a normal, pre-pandemic February, but lower than it was a year ago on a non-seasonally adjusted basis. One cautious conclusion would be that, even though inflation is still higher than it was prior to the pandemic, the underlying trend is toward falling inflation pressures, likely opening the door to at least one rate cut later this year.

Retail Sales’ Slump Implies Consumer’s Zest for Spending is Fading

Against consensus expectations of a 0.8% increase, headline retail sales for February came in softer at 0.6%. What’s more, the retail sales numbers for January and December were revised lower; the January numbers were revised from -0.8% to -1.1%, and December’s reading was revised from 0.4% to 0.1%. Control-group retail sales – which excludes spending on vehicles, gas, food services, and building materials – was flat at 0% (vs a revised -0.3% prior), below the consensus estimates for 0.4% growth.

Remember that the almighty US consumer is responsible for ~75% of all US economic activity, thus their spending habits are a harbinger of the state of America’s economy. Bottom line? The data tells us that consumers’ zest for spending is probably fading, and the brisk pace of spending seen late last year is likely behind us with a slower period of spending growth ahead.

What to Watch: Was the Fed Wrong to Pivot Back in January?

It’s well-known that Fed Chair Powell is highly sensitive to surprises, especially those that involve signals of slowing economic growth. This dynamic was witnessed late last year, when the unemployment rate was believed to have increased to 3.9% back in October, only to be revised down to 3.8% later in the year.  Those expectations – combined with a sour reading of regional economic conditions (via the Fed’s Beige Book) sparked talk of an impending recession.

Chair Powell’s reaction? The now infamous Fed pivot toward rate cuts in December. With sticky inflation and a still-strong jobs market, was the pivot a mistake? Probably not, given the fact that, despite those factors, the overall economy has performed well, currently growing at a robust 2.3% pace.

Fast forward to now. The unemployment rate is back at 3.9%, higher inflation readings in January and February are concerning and surveys of businesses indicate that prospects for hiring and new orders are not exactly popular. The 10-year Treasury yield has increased by nearly 40 basis points since the January Fed meeting, increasing both residential and commercial mortgage and corporate borrowing costs. Given the negative signals, will the Fed Chair stage another “pivot” toward rate cuts at this Wednesday’s monetary policy meeting? Given recent history, it’s likely. Either way, we don’t know about you, but we’re tired of being teased into hoping that rate cuts are right around the corner.

No one expects any rate move by the Fed this week, as slowing consumer spending, a strong but softening jobs market combined with sticky inflation present conflicting risks that make any Fed move on rates – higher or lower – the wrong one right now. The Fed is also not in the business of creating clarity, and this week’s meeting won’t change that. All told, it will likely be one of the most boring Fed meetings this year as we all continue the Fed rate cut guessing game. We are in a rare dynamic though, where markets, expecting three rate cuts this year, are aligned with the Fed, who, as of last December, per their Statement of Economic Projections, also implied three cuts this year.

That alignment will likely evaporate this week, as the Fed updates both its projections as well as releases its updated dot plot, which will give us a refreshed peek into what the Fed is thinking in regards to the timing and degree of rate cuts. We suspect the revised dot plot will imply two, 0.25% rate cuts by the end of the year, as the Fed has likely become more concerned about the recent inflation data and less convinced that inflation will resume its earlier soft trend. We’ll see how markets react, but it’s a certainty that they’ll also revise their rate cut expectations to a level that’s far lower than the six 0.25% cuts markets expected at the start of the year.

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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