Two More Hikes Then A Pause

What You Missed

Markets re-priced how high the Fed will hike interest rates given the turbulence brought on by Silicon Valley Bank’s (SVB) failure and the negative ripple effect it’s had on the banking sector. The overarching fear now is that ballooning concerns over financial stability will cause banks to tighten lending standards, further subduing economic activity while increasing the chances of recession. Even though the likelihood of a recession has now increased, the threat of higher inflation endures courtesy of the tight jobs market. What’s a central bank to do? We expect the Fed to hike interest rates by 25 basis points at its policy meeting this week, then hike another 25 basis points in May – pushing the Fed Funds rate to a cycle peak of 5.25% – then pause for the rest of year. Keep reading for our reasons why.

After a wild ride through the entire week, yields across the maturity spectrum ended much lower from where they started. For the week, the 2, 5, 10 and 30-year Treasury yields fell 74, 46, 27 and 9 basis points, respectively. Of note is the 2-year Treasury yield’s swift fall from 5.07% on March 8^th to 3.87% on March 17^th, the largest drop in a nine-day span since the Black Monday stock market crash in October 1987.

By Friday afternoon, markets had dialed back the erratic movements as it looked that bank runs had been slowed by government safety nets and rescue measures. The fall in short-term yields released some pressure in the 2s-10s yield curve, a widely watched barometer of looming recession, to -41 basis points, well off its most inverted level of -108 since the 1980’s, briefly seen a couple of weeks ago.

Elsewhere, global equities were little changed on the week having withstood several bouts of volatility as investors reacted to a steady stream of banking-related headlines. The price of a barrel of West Texas Intermediate crude oil fell $10 to $66.50 amid concerns over weaker global growth, while the US Dollar and Gold both strengthened.

**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.**

Hedging Costs Spike Despite Fall in Rates

3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, backed further off all-time highs near 5.12% for the second week, falling to 4.85%. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘24), a rough estimate of where markets expect 3-month Term SOFR to be a year from now, fell 13 basis points from this time last week, to 3.83%, reflecting more fallout from the sudden, SVB-inspired belief that the Fed may not hike rates as high as previously thought.

The SOFR futures market, a widely observed signal for how SOFR will behave in the coming months, implies that 3-month SOFR is already close its peak of 5.00% (it’s 4.75% now), and expects a following significant decline over the next year as the Fed eventually eases.

Finally, interest rate volatility, a key driver of the cost of interest rate caps, surged to eye-watering levels last seen during the 2008 financial crises (even higher than that seen during the onset of COVID), at this point derailing hopes of lower rate cap costs emanting from lower short-term yields.

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.

Banking Crises – A Quick Study

Throughout history, a true crisis in the banking sector has been notoriously difficult to define, let alone quantify, given that institutional balance sheet data are infrequently available, and crises can result from a wide range of causes. Usually they’re defined by 1) One or more bank runs that result in the closure, merger, or takeover of one or more financial institutions (check!), or 2) in the absence of bank runs, the closure, takeover, or extensive government assistance of a significant financial institution, which signals the beginning of a series of similar outcomes for other financial institutions.

The first criterion for a banking crisis would be satisfied by Silicon Valley Bank’s and Signature Bank’s failing because of large deposit outflows. If only the second criterion were met, the situation would not yet be considered a true “crisis” despite Credit Suisse’s shotgun marriage to its archrival and Jim Griffin’s last banking employer, UBS, as it’s only a single large bank that’s feeling the pain as opposed to a string of closures, mergers, and takeovers.

The actions of the previous few days all fuel the assumption that the banks had a liquidity problem – meaning they had difficulties raising funds in a hurry – rather than a solvency problem, which would suggest that they have to absorb losses on their assets. If the problem is solely one of liquidity, then the situation justifies just a 25-basis point rate hike this week.

The important take-away here is that a true banking crises usually brings with it a reduction in lender’s appetite to lend, which therefore supresses demand, bleeds into a slowdown in inflation which eventually morphs into falling inflation lingering a couple of years after the event.

If we’re in a true, full-on banking crisis, then the Fed shouldn’t hike at all. If we’re not really in one amid still-strong inflation, then a 50-basis point hike could be justified. We’re guessing that we’re somewhere inbetween the two, and that the Fed will do its best to thread the needle knowing that at this point it is challenging for it to avoid making a mistake of some sort no matter what they do.

In the three decades that we’ve have been in this business, this is the first Fed meeting that we can recall when economists anticipated a hike (the broad consensus), no hike (Goldman Sachs and Barclays, among others), and a rate cut (Nomura.) Some are even still advocating for a 50 basis point rate hike. Good times.

Banking Turmoil Replaces Need for Rate Hikes

Amid the banking stress brought on by SVB, which has now spread to other, smaller American banks and a major bank, Credit Suisse, financial conditions have clearly tightened. The prior robustness of the economy has now deflated somewhat, giving the Fed more optionality in its choice to hike rates further in fighting inflation.

Should the crises linger into April and May, in the form of lingering financial stability concerns, tighter lending standards and slower credit growth, it will have supplanted the Fed in slowing the economy, eliminating the need for more rate hikes. However, the crises’ impact will be minor if the unrest abates in the next few weeks. The most likely outcome in our view, given the speed and scope of the FDIC’s, US Treasury’s, and the Fed’s reaction, will likely be somewhere in between the two scenarios, with the economic damage equating to a 25-basis point rate hike. That being said, markets are probably overreacting in cutting their peak-Fed Funds rate expectations by ~65 basis points, from 5.51% before the crises to just 4.86% now.

Latest Inflation Gauges Paint a Mixed Picture

In February, underlying US consumer prices – via the Consumer Price Index (CPI) – increased more than they had in the previous five months, forcing the Fed to choose between addressing enduring high inflation and calming banking turmoil in its interest rate policy decision this week. The consumer price index rose 0.5% last month and 5.5% from a year earlier, excluding food and energy. About 70% of the increase in the overall CPI in February was attributable to shelter, which also saw a 6% increase from the prior year. The median projections predicted that both the core and total CPI measures would increase by 0.4% last month.

On the flip side, an unexpected decrease in the producer Price Index in February adds another piece of data to the “totality” of evidence, which lessens the need for the Fed to raise rates this week. The Fed’s preferred inflation indicator, core PCE inflation, which considers both the PPI and CPI data, likely stabilized at 4.7% in February. Core services excluding housing, the Fed Chair’s “supercore” metric, most certainly slowed from January’s blistering pace.

What to Watch This Week – Cracks in the Fed’s Resolve

When European Central Bank (ECB) President Christina Lagarde stated at her news conference – which occurred after she chose to hike interest rates by 50-basis points – that there is no trade-off between financial stability and price stability, Fed Chair Powell most likely paid close attention. She argued that there are separate instruments available to combat inflation and prevent financial instability. Powell will have the chance to make the same claim at this week’s rate setting meeting (Wednesday).

This Wednesday, the FOMC must make one of its most difficult policy decisions in recent memory. During the past week, market expectations have fluctuated dramatically, from a 50-basis point hike following Fed Chair Powell’s semi-annual address to Congress to an expectation of no hike as crisis erupted surrounding Credit Suisse. We’re aligned with the markets in expecting a 25-basis point hike, bringing the fed funds rate’s upper bound to 5.0% from 4.75%. But we also see a non-trivial possibility that the committee might take a break to assess the situation, while still indicating through the updated Summary of Economic Projections that the break is only temporary and that policymakers still expect to hike rates further.

This is not the moment for the Fed to relent, given that inflation is still so high. The current banking crisis may have a more negative effect on the actual economy, but the fact that we’re living in the presence of a true crisis is neither a given nor even a likely outcome. High inflation, meanwhile, is a reality that has persisted despite the Fed’s best attempts to smother it over the past year. As such, this Wednesday’s rate decision will be a true test of the Fed’s commitment to its inflation fight.

If the Fed hikes rates this week as predicted by economists, that decision may ultimately be viewed as a policy blunder in which the central bank ignored financial stress in favor of focusing only on the one inflationary needle on its policy compass. Conversely, if they choose no rate hike or cur rates, they may not believe their own claims about the stability of the financial system.

Strategy Corner

Are you contemplating a rate cap extension or purchasing a replacement cap? With rates much lower, now would be the time to do it.

Concerned about where term rates will be when your loan matures 6-months, one-year or two-years from now? With the long-term future direction of rates murky, you should be. Lucky for you, there are ways, using derivatives, to reduce the uncertainy around what rate you’ll pay when you refinance, and ultimately, protect yourself against higher term interest rates over the long-haul.

For a sneak peak into real world results from such a strategy, check out this recent article in the Wall Street Journal (warning, paywall): Chicago Property Developer Scores With Audacious Interest-Rate Bet – WSJ

Structuring a hedge to mitigate future term rate exposure involves careful planning and expert advice. We’ve been discussing this type of strategy for literally years: Swaptions: What Smart Borrowers Are Doing Now – Derivative Logic . Call us to discuss your future funding concerns and for help with planning and executing a strategy that’s custom designed just for you.

Mitigating interest rate risk is dynamic and not static. The complacency of believing rates would stay low forever caught both borrowers and lenders off guard. Now that the paradigm of low rates forever has changed, both borrowers and lenders look for ways to ease the pain that higher interest bring to the table. Interest rate derivatives can provide some with the perfect solution, but it comes at a cost. Another strategy chosen by some is to do nothing. Doing nothing is definitely a strategy, but doesn’t mean borrowing floating or fixed and forget it.

Derivative Logic prides itself in education and structuring hedges that make sense. There are times when we suggest doing nothing, but we provide the analysis of how we came to that conclusion. Our focus isn’t based on earning transaction fees but on doing the right thing. Just ask our clients. Give us a call (415-510-2100) for a complimentary review of your capital structure. We might say your capital structure doesn’t require our services yet. Let us emphasize YET.

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