Threats to Fed’s Soft-Landing Narrative are Growing

Running the Numbers: Rates Surge on Hawkish Fed

For the week:

2-year Treasury yield: up 7 basis points to 5.12%

5-year Treasury yield: up 15 basis points to 4.60%

10-year Treasury yield: up 21 basis points to 4.51%

30-year Treasury yield: up 24 basis points to 4.62%

1-month Term SOFR: down 1 basis point to 5.32%

Where will SOFR be a year from now? 3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, fell one basis point to 5.39%. The implied yield on the 3-month SOFR futures contract 1-year forward (September ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, rose ten basis points point week over week, to 4.96%, reflecting the new market view that the Fed may hike rates again and keep rates higher for even longer than was previously believed.

How much higher will SOFR rise? The SOFR futures market, and the forward curve it projects to the world, implies that 3-month SOFR is already near its peak, and forecasts that it will peak by year’s end, at 5.47%, then decline consistently over the next year as the Fed eventually cuts interest rates in Q2 2024.

Will rate cap costs ever decline? Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, rose on the back of last week’s Fed meeting, but is still close to low levels last seen in February 2023. Any decline in rate volatility helps to drive rate cap costs lower. However, rate volatility is still high historically, and until there are clear signs that the Fed is on a rate cutting tilt, rate cap costs won’t decline precipitously.

Elsewhere, equities were lower on the week amid the surge in Treasury yields across the curve. The price of a barrel of West Texas Intermediate crude oil added $0.50 to $90.50 while the price of a barrel Brent crude reached $95 before easing slightly. The US Dollar strengthened and Gold both weakened.

Fed’s Dot Plot Implies Rates Will Stay Higher for Even Longer

Despite the Fed leaving rates on hold, last week’s Fed meeting – via the Fed’s release of revised interest rate forecasts (aka the “dot plot”) and Summary of Economic projections – sent markets reeling. Here’s the breakdown:

1. The Fed voted unanimously to leave its benchmark Fed Funds rate unchanged in the target 5.25% – 5.5% range as widely expected. The big revelation was that the Fed is now forecasting considerably higher rates over 2024 and 2025 due to what it believes will be a resilient US economy, a strong jobs market amid sticky inflation pressures. Moreover, the Fed seems to have completely scrapped any recession forecast for this year.
2. The Fed’s dot plot of rate projections – revised every quarter – showed that the Fed rate-setting committee members still foresee 1) one more rate hike this year, and 2) that interest rates will stay higher for even longer as their 2024 and 2025 rate projections each rose by 0.50%, to 5.1% (vs. 4.6% prior) and 3.9% (vs. 3.4% prior), respectively. We’ve always felt that markets tend to over-emphasize the dot plot and economic projections, as the dot plot usually turns out to be dead wrong in hindsight. For more info on why, see an old Straight to Smart we wrote on the topic.
3. Fed Chair Jerome Powell, in the post-meeting press conference, stated that the Fed’s goal is to achieve an economic soft-landing, with little damage to the jobs market, while acknowledging that such an outcome is possible but far from guaranteed. The Fed Chair also acknowledged that the risks to hiking rates too much, sparking a recession, versus too little, and sparking renewed inflation pressures, is now more “two-sided”.
4. Financial markets took the higher-for-longer message to heart, with the 2-year Treasury yield, which is highly impactful on the cost of interest rate caps, climbing to its highest level since 2006 on the news. Elsewhere, the 10-year Treasury yield briefly breached 4.5%, its highest since 2007, as credit spreads widened, and equities sold off.

Our take: While the dot plot now implies another rate hike before the end of the year, we’re doubtful it will happen given the number of growth shocks that loom on the horizon. We’re betting that the Fed will keep the Fed funds rate steady for the rest of the year, as the looming government shutdown, high oil prices, lingering economic uncertainty and disruptions from the auto worker strikes all conspire to push the Fed to postpone a hike to 2024 or even nix it completely. As for rate cuts, we still don’t expect the first to show up until Q4 of 2024.

Could $100 Oil Threaten the Fed’s Soft Lang Narrative

With crude oil hovering near $100 a barrel, inflation pressures will remain high even as growth slows in many parts of the world, bringing the Fed’s soft-landing narrative into question. While oil’s price direction over the longer-term future is unpredictable, know that high oil prices often act like a tax on consumers, reducing their demand for other goods and services as well as inducing uncertainty about their economic future.

Despite these effects on supply and demand, the correlation between oil price increases and economic downturns in the US is far from perfect, as not every sizeable jump in the price of oil has been followed by a recession. However, five of the last seven U.S. recessions were preceded by notable increases in oil prices.

However, while the jump is oil prices is grabbing headlines, oil prices have risen lately by only $20 per barrel, and when compared to the +$40 rise seen in the first half of 2008 and +$45 in the first half of 2022, we’re guessing that oil needs to rise much more to have any real, lasting impact on the eocnomic lives of consumers.

High Rates are Driving Developers Toward Multifamily

The effects of past Fed rate hikes continue to show up in developments in the housing market, as evidenced by recent data from the NAHB. August’s existing-home sales dropped by 0.7% and the rate of housing starts fell by 11.3% month over month, mostly due to rising mortgage rates. Building permits, a leading indicator of housing demand, were up 6.9% to an annualized pace of 1543k units in August. That was stronger than the consensus estimates of 1440k.  Building permits for single-family homes increased 2.0%, while permits for multifamily were up 15.8%, implying that prospective buyers are beginning to tilt more toward new construction and multifamily properties since existing homeowners are reluctant to sell while they’re locked into older mortgages at lower fixed interest rates.

As such, developers are seemingly now more motivated to concentrate on obtaining multifamily development permits to fill anticipated demand. An interesting wrinkle in the report was that apartment construction seems to be shifting toward lower-density markets and suburbs, and away from large cities.

What to Watch: Fed’s Preferred Inflation Gauge to Remain Soft for Third Straight Month

According to its most recent Summary of Economic Projections (SEP), the Fed is confident that its interest rate decisions are on course to create a scenario known as “immaculate disinflation,” in which inflation falls without significantly harming the jobs market – i.e., driving unemployment markedly higher – in the process. Unexpectedly, the Fed’s certainty in such an outcome seems to be growing, despite the emerging triple threat of rising oil prices, UAW strikes, and a possible government shutdown.

Jobs market data (via jobless claims, Thursday) will seem to confirm that confidence. But we’d caution the Fed not to rely too much on backward looking jobs data in making its predictions, as it has a poor historical record of predicting recessions. Still, the data for the upcoming week is unlikely to undermine the Fed’s optimism for now. The August PCE inflation gauge (Friday) – a data set known for capturing an accurate read on inflation across a wide range of consumer expenses and reflecting changes in consumer behavior – probably stayed near the Fed’s 2% target for a third consecutive month, even though spending and income both increased at a respectable rate. Nevertheless, we do anticipate more evidence of a worsening jobs market in the consumer confidence report (Tuesday).

Elsewhere, the Fed’s pivot toward a more aggressive path of interest rates last week has prompted markets to adjust expectations for the overall path of rates, with the 10-year Treasury yield recently 4.50%.  The next target is 4.72%, but some momentum indicators suggest a pause may occur in the near term.

Strategy Corner: Let’s Talk Interest Rate Swaps

We’ve seen a rise in bank loans for refinancing bridge debt of late.  The large and regional banks offer floating rate loans and swaps to synthetically fix the rate.  The borrower is paying the floating index plus the credit spread on the loan.  The swap, a separate contract from the loan, obligates the borrower to pay a fixed rate and receive the floating index. Simple math, the pay floating and receive floating offset, and the result is the borrower ends up paying a fixed rate plus the credit spread.

Swaps are an ideal way to manage floating rate risk.  A swap can be structured in ways that mitigate risk tailored to the spcific goals and objectives of the borrower.

Important points to consider before executing an interest rate swap:

1)            The bank selling to swap to the borrower earns fee income by adding a spread over the market swap fixed rate.   A swap is an obligation to exchange interest payment streams (pay fix – receive floating) which means there is risk of default.  The bank’s spread is the fee it receives for underwriting the default risk.

2)            Swap spreads almost never correlate to the risk a bank is assuming, and in some cases, the fee income can exceed double-digits.  The bank records the swap fee income on day one, a huge bump to their fee income versus recognizing the fee income over the life of the swap.

3)            Fee income is based upon the Present Value of a 1 basis point change in the swap fixed rate multiplied by the swap spread.  Assume a $25mm, 10-year term/25-year amortizing swap. The market rate is 4.00%, PV01 = $18,230, and the bank spread is 0.25%.  Bank fee income: 25 x $18,230 = $455,750.  All-in fixed rate to the borrower is 4.00% + 0.25% + Credit Spread.

4)            The bank is incented to have the borrower hedge as much of the loan amount as possible and for as long as possible.  Bank swap presentations always include a “non-reliance” disclaimer clause and “strongly recommend” hiring an independent advisor, as the bank clearly states that it isn’t giving the borrower hedging advice, is acting in their own interest, and is not acting as the borrower’s fiduciary.

5)            The swap contact between bank and borrower is called the ISDA Agreement, and is comprised of two parts: the ISDA Master and the ISDA Schedule. The ISDA Master is like the Webster’s dictionary and is standard stuff and never negotiated. The ISDA Schedule is highly customized to the specific borrower and swap, and is the document where the “devil is in the details”.  If you’re a borrower, NEVER sign the ISDA Schedule without having an attorney or advisor review it first.  A non-negotiated ISDA Schedule is always in favor of the bank.

6)            Derivative Logic is an independent, expert hedge advisor that can guide you through the process and provide the education to execute a hedge knowing the proposed structure is suited for a borrower’s particular goals and objectives.

7)            Many borrowers are concerned about introducing an independent derivative advisor to the team because they are worried the bank might push back or closing may be delayed.  If a bank recommends the borrower not hire an attorney that should be a red flag and alarm bells should go off in a borrower’s head.

We have an excellent reputation amongst the banks because we don’t negotiate with a baseball bat.  They know we are team players.

How can Derivative Logic help?

1)            Propose hedging strategies based on the borrower’s goals and risk tolerances.  Fixing all the debt for the entire term of the loan can often lead to adding, rather than reducing, interest rate risk.  We have many stories to share about borrowers going at it alone and ending up with a costly, undesirable outcome.

2)            Swap fee cost savings through effective hedging structures and working with the lender to reduce the swap spread.

There is more to the process and we can provide a proposal of our services and fee structure.  Call us for more information on how we can help.  We also offer an in-person or Video presentation of our Derivatives 101  seminar.

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