U-turn Wrecks Rate Cut Dreams

What You Missed

Yields across the maturity spectrum leaped higher for the second week, fueled by a slew of economic data that showed inflation is more enduring than markets had anticipated. The rising yields show that markets continue to slowly cave to the Fed’s incessant “interest rates are going higher and staying there longer” drumbeat. Last week’s evidence was presented in the retail sales and consumer and producer price reports, which all demonstrated the economy’s resiliency, supporting Fed Chair Jerome Powell’s assessment that the battle against inflation is still far from over.

Investors have now priced in a higher peak for how high rates will go, as well as scaled back their bets on any rate cuts by year’s end. Interest rate futures now project that the Fed Funds rate – that’s the rate the Fed raises of lowers as it affects interest rate policy –  will peak at 5.30%. It’s 4.75% now, implying that we’ll see at least another 50-basis points in hikes before the Fed has completed its hiking cycle. This change brings the market outlook closer to the Fed’s own December estimates, which we believe is how future rate moves will likely play out.

For the week, the 2, 5, 10 and 30-year Treasury yields rose a respective 10, 12, 11, and 10 basis points. The 2s-10s yield curve, a widely watched barometer of looming recession, ended the week at -0.81%, just shy of its mid-week high of -0.86%, its most inverted level in 42 years. Overall, the continued jump in yields, an about-face from their falling trend over the last few months, reflects a new awareness from financial markets that the Fed is serious, while still expecting rate cuts before the end of the year. Want to know when the fixed income markets have fully capitualted to the Fed’s view of “higher and for longer”? Watch the 2-year Treasury yields breach of 4.72%, its November 2021 peak. It’s at 4.70% now.

Elsewhere, global equities were little changed in the week on the back of the yield move.  The price of a barrel of West Texas Intermediate crude oil fell $3 to $75.50, as the US Dollar and Gold both weakened.

Hedging Costs Hold Steady

3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, held its recent levels near 4.56%, just shy of its all-time high of 4.57%. 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 will be a year from now, rose 16 basis points from this time last week, to 4.67%.

The SOFR futures market implies that 3-month SOFR will now peak in the fall – as opposed to its previous prediction of late spring – near 5.52% followed by a gradual decline over the next three years as the Fed eventually eases. Interest rate volatility, a key driver of the cost of rate caps, maintained its accelerating trend, raising rate cap prices in the process. We still expect rate volatility to continue to moderate over the long term, and rate cap costs continue to fall, with some bumps higher in between, as the end of the Fed’s rate hiking campaign inches closer.

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.

Inflation Pressures Reignite the Higher-for-Longer Rate Theme

We’re in the midst of an economy that just won’t quit, as evidensed by producer and consumer prices that moderated less in January than was expected. The Consumer Price Index (CPI) rose 6.4% from a year ago, down slightly from December’s 6.5% pace, and rose 0.5% from the prior month. When translated to PCE inflation – the Fed’s preferred gauge – the headline inflation figure may be around 4.8% on a 12-month basis, far above the Fed’s 2% target. Core CPI decreased to 5.6% on an annual basis from 5.7% in December but remained constant at 0.4% month over month (December’s print was revised up to 0.4%). It will likely continue to decline in the coming months due to base effects.

All told, on a 1, 3 or 6-month annualized basis, gauges the Fed uses to assess inflation’s momentum, January’s headline CPI was running at 6.4%, 3.5%, 4.1%, respectively – all up from the previous month. Core inflation was also up across those measures, at 5.1%, 4.6%, 5.3%, respectively.

On the Producer side of the coin – think of prices on the wholesale level – the theme of newly accelerating inflation is the same. The Producer Price Index (PPI) for final demand increased 0.7% month over month, far above the 0.4% expected. Additionally, last month’s PPI data, which showed a 0.5% decline, was revised up to -0.2%.

As such, the worse than expected inflation data has forced markets to now expect a higher peak for interest rates, as well as pushed out any rate cuts to late in 2023.

Our take: The inflation data is discouraging for any hopes that the Fed will end its rate hiking campaign anytime soon, let alone cut interest rates. The data showed that inflation’s recent declines – fueled mostly by declines in the prices of goods – are waning. If there’s any hope for inflation to get back on its declining trend, the catalyst will have to come from falling prices for services. With no sign of that happening anytime soon, the Fed will keep up its inflation fight with gusto, in the form of more rate hikes in both March and May, with any rate cuts showing up in 2024 at the soonest.

“No Landing” Economic Scenario Gains Steam

The big story of 2022 wasn’t just how fast interest rates rose. It was how easily the economy has withstood higher rates, and it has caught everyone by surprise. Regardless of your unique view on inflation, everyone has assumed that if you take short-term interest rates from basically zero to 5% in the span of a year or so, then you’d surely see weakness in the jobs market. But that weakness just hasn’t shown up yet, driving fresh speculation of higher interest rates and rates that will stay higher for longer than most expect.

After months of debate over whether America’s economy will face a hard or soft landing, the debate is slowly shifting to whether the economy will land – via an economic downturn – at all. Despite having endured 450 basis points of rate hikes in less than a year, a parade of stronger-than-expected economic data shows that the economy is proving remarkably robust.

Among some of the latest positive surprises, retail sales in January rebounded by 3%, more than reversing a 1.1% fall in December. Financial markets – following on the heels of a strong January jobs report and signals that inflation may moderate at a slower pace going forward – are beginning to contemplate a “no landing” scenario in which the Fed continues hiking rates amid a rebound in economic activity. While such a scenario seems benign on the surface and could allow the economy to avoid a recession this year, it would likely just postpone a recession until 2024.  A dynamic to watch for certain.

What to Watch This Week: Continued Focus on Inflation

The Personal Consumption Expenditures (PCE) deflator (Friday), aka consumer spending and the Fed’s favorite inflation indicator, doesn’t typically elicit much market reaction, as it typically provides few fresh signals following the attention-grabbing CPI and PPI data. However, with inflation dynamics being what they are, it’s different this time.

The PCE deflator for January is expected to indicate that both headline and core inflation increased not just month over month, but year over year. Fed Chair Powell’s favored inflation metric, PCE core services excluding housing rents, unique to the PCE report, also likely rose back above 5% on an annualized monthly basis.

Given the improvements in supply chains, staffing and the normalizing of business inventories, the fact that inflation’s fall is stalling should surprise you. This implies that fresh spikes in inflation are probably right around the corner.

What’s driving the U-turn in inflation? A stabilizing housing market (existing home sales, Tuesday ), a tight jobs market (initial jobless claims, Thursday ), and robust household income growth have all contributed. Nonetheless, we still anticipate a steady decline in demand over the course of the year as lower-income households use up their excess savings (savings are included in Friday’s PCE report).

The billion-dollar question now? If recent signals of resurgent inflation prompt the Fed to recalibrate its desired peak for interest rates. It probably hasn’t yet and will likely choose to stick to its implied plan for a peak Fed Funds rate of 5.25% and for no planned rate cuts this year for now. The Fed probably has until June or so before it must determine whether to raise rates above 5.25%.  By then, rents – one of the factors the Fed focuses on intently – ought to have declined by then, and the jobs market will have softened some. If neither of those occurs, the Fed will likely have to hike the Fed Funds rate higher than most expect, above 5.25%. That implies that 1-month TERM SOFR peaking somewhere near 5.50% (it’s 4.56% now).

Big Picture – A Higher Peak for Rates with Cuts Coming Later

The January CPI data showed that inflation is moderating much slower than the Fed would like, and should the trend continue, giving the Fed justification to hike interest rates by 25-basis points two to three more times. Financial markets still believe that rate cuts will show up by the end of the year. To squelch these beliefs, the Fed will likely become more explicit that it won’t cut rates until the jobs market cools and inflation is on a firm, multi-month decline.

Strategy Corner

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.

Current Select Interest Rates:

Rate Cap & Swap Pricing:

Forward Curves:

10-year Treasury Yield:

Source for all: Bloomberg Professional

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