View from the Peak

Running the Numbers: Short-Term Rates Near their Cycle Peaks

For the week, the 2, 5, and  10-year Treasury yields rose a respective 9, 4, and 1 basis points, to 4.83%, 4.06%, and 3.81%. The 30-year Treasury yield fell 4 basis points to 3.89%.

Top Wall Street economists are now frequently repeating the same message: The chance of a recession is rapidly fading. However, the bond market continues to signal a warning that an economic downturn is near, via an inversion of the yield curve: high yields on short-term debt and lower ones on longer term bonds as traders anticipate the Fed will start cutting interest rates next year. The inversion is extreme at  -102 basis points, backing off an ultra-extreme inversion near -108 seen a couple of weeks back. The 500 basis points of rate hikes in this cycle makes it difficult for the group still wedded to the conventional interpretation of an inverted yield curve to ignore. They predict that when banks cut back on lending to businesses and households, the economic pain will eventually show up with gusto.

Our take? Interest rates have risen to such high levels in such a short period of time that long-term yields indicate the Fed will likely end up cutting rates gradually, toward more normal levels rather than drastically cutting them to boost growth. For now, swaps traders are pricing in a quarter-point rate hike on July 26, and about 30% odds of another one by year end. Swap markets still predict a rate cut by the end of this year, reflecting the seeming resilience of the US economy, but one that falls into a mild recession in Q4 2023.

3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, rose 3 basis points to 5.35%. The implied yield on the 3-month SOFR futures contract 1-year forward (June ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, rose 16 basis points point week over week, to 4.72%, reflecting the accumulation of less than encouraging economic data that implies short-term rates will go higher in the near-term, but that they’re very close to their peak.

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 to peak in the fall, at 5.40%, then decline consistently over the next year as the Fed eventually eases.

Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, fell consistently through the week to levels last seen in a month ago. Elsewhere, equities were higher on the week but off their best levels after a few weaker-than-forecast tech earnings reports. The price of a barrel of West Texas Intermediate crude oil rose $3.34 to $77.49, while the US Dollar strengthened and gold weakened.

Recession Bets Now a Toss Up Amid a Weakening but Resilient Economy

As inflation declines and the economy proves resilient to the Fed’s incessant rate hikes, some forecasters – including us – who were among the first to anticipate a US recession are beginning to hedge their bets. It’s effectively a coin flip now as to whether the economy faces a recession later this year or experiences a soft landing and keeps growing.  Sales of new cars, home prices, and housing starts have all outperformed forecasts, supporting the economy. The most recent Consumer Price Index (CPI) report revealed that the US inflation rate fell in June to a level that was lower than two years ago. Paradoxically, the Fed’s aggressive rate hikes have helped to re-anchor inflation expectations, raising the likelihood that price pressures will ease without a material decline in the economy.

However, the most recent jobs report showed that demand for temporary help services, one of the best leading indicators of the business cycle, was weak. This creates a dilemma for the Fed, in that it implies that rate hikes, designed to smother inflation, also clearly contributed to growing unemployment for those who are most vulnerable economically. It’s a scenario that strengthens the argument that keeping interest rates steady after this week makes sense, especially if signals of the uneven impacts of past rate hikes persist in subsequent jobs reports.

Lower Retail Sales Add to Slowing Economy and Last Fed Hike Theme

Headline retail sales in June rose a modest 0.2%, vs. an upwardly revised 0.5% in May. That was softer than the consensus expectation of +0.5%. On an annualized basis, those data show that retail sales slowed to a stop in Q2, clearly indicating signs of a downturn.

Why it matters: Retail sales, a direct indicator of spending activity by the US consumer, who alone is responsible for a whopping 70% of US economic activity, will likely slow even further, on the back of slower wage growth and a tightening of consumer credit. By extension, it will add momentum to softening inflation pressures as consumer demand declines. The dynamic adds more credence to the belief that this week’s Fed hike will be the last of the cycle.

What to Watch This Week – Fed Hike in the Bag

Most Fed members justified their choice to “skip” an interest rate hike at the Fed meeting last month as buying time to “assess the economy’s progress.” Too bad for the Fed, as economic data since then have painted a confusing picture: Inflation and jobs data were softer than expected in June, but most other economic indicators surprised to the upside.

The mixed bag of data has likely failed to settle the Fed’s internal debate about whether this week’s hike should be the Fed’s last.  Fed Chair Powell’s comments at the post meeting press conference will therefore probably appeal to both those who feel the Fed should hike further and those who don’t. Powell will likely state that the road to a soft economic landing has become clearer amid easing inflation pressures and a less-worrying economic outlook, implying that the Fed May officially take a wait-and-see approach as its next policy meeting in September approaches, leaning on the unpredictability of the lag that rate hikes have on the economy, while cautioning that several Fed members still expect one more rate hike this year.

Regardless of the confusion, a 25-basis point rate hike is widely expected this Wednesday, and we suspect that the Fed will pause on further rate hikes or cuts for the remainder of 2023.

What Comes After the Fed’s Last Rate Hike?

What happens beyond 2023 is harder to predict. Although we expect the Fed to begin cutting interest rates in Q2 2024, there are several possible scenarios that could result in another rate hike, believe it or not.

For instance, if the El Nino weather trend this year proves to be particularly potent, it could shock the world’s food prices higher in the next year. In the past, strong El Ninos have caused food prices to spike, and there are already indications that this summer’s excessive heat has harmed crops in important food-producing nations.

In an alternate scenario, the economy may avoid a recession and accelerate next year. Although the probability is low, some economic indicators have signaled such. Consumer confidence has been rising recently (released Tuesday); second-quarter GDP growth and durable goods orders have both been solid (both Thursday); and the housing market appears to have stabilized or even accelerated (new home sales, Wednesday; pending home sales, Thursday). If such were the case, we would expect a return to hot core inflation and a rise in inflation-stoking housing rents toward the end of 2024. That would mean that a Fed Funds rate of 5.5% – its level after this Wednesday’s 25 basis point hike – could become just a temporary pit stop in the Fed’s stop-and-go tightening cycle.

The most intriguing question beyond whether there is another hike after this week is the question of what set of economic conditions would cause the Fed to cut interest rates. We believe the answer to that question is dependent on whether the US economy finds itself in a recession next year or not.

We think the bar for the Fed to cut interest rates is high. If growth in the coming year is close to (or above) potential, the unemployment rate is still very close to multi-decade lows, and financial conditions have loosened further, the Fed may not view preemptive easing as prudent from a “risk management” perspective.

In looking at history, over the past few decades when recessions were avoided, the Fed cut by only 75-100 basis points after an extended hiking cycle, and the easing was short lived. Market expectations of rate cuts during that time weren’t consistent. in some cases, forward curves projected only modest cuts, other times curves implied rate cuts of as much as 125 basis points.

Alternatively, over the past few decades when America’s economy found itself in a recession after an extended hiking cycle, the Fed cut rates more than markets expected. Currently, forward curves imply that the Fed will cut interest rates by about 230 basis points over the next five years; that’s more than what was seen prior to the recessions of the 1970s and the early 1980s.

Bottom Line: Fed rate cuts next year will be dependent on whether we find ourselves in a recession or not, and if so, how deep of a recession we’re in. If a recession is avoided, don’t expect the Fed to cut much at all, regardless of what the SOFR forward curve implies. If we do indeed enter a deep recession, expect the Fed to cut rates more than what the curve implies. The most likely scenario? A mild recession late this or early next year, where the Fed cuts interest rates less than a handful of times at most, but only does so gradually, say by 25 basis points every three months.

Call us to discuss all the ways to mitigate risk without sacrificing flexibility.  Borrowers should seek an advisory firm that provides an objective view, that has capital market experts who provide guidance based upon analysis and not emotions.  Derivative Logic is that firm.

Recent Insights on Defeasance

A client called to discuss an opportunity to refinance a bridge loan with a CMBS.  The client was asking how to limit risk if eventually term rates fall but didn’t consider how their credit spread will impact their exit costs. The real concern the borrower had was minimizing the risk of a fall in long-term rates. 

The only way to refinance a CMBS is to defease. Recently, some CMBS borrowers were able to defease and actually receive a payment.  The uncommon circumstances we saw earlier this year meant the stars had aligned.  The original benchmark interest rate was substantially below current long-term rates and the difference exceeded the credit spread.  For example: Benchmark rate 2.75% + credit spread 3.00%, all-in 5.75%.  Term rates rise to 5.00% + 3.00% all-in 8.00%.  Does it make sense to defease and refinance by monetizing the value of the below market rate loan? 

That is when you should call Derivative Logic to help you with the analysis because there are too many variables to consider.  However, our website has a defeasance calculator that’s handy to use as a starting point.  It usually makes economic sense if the credit spread is lower and terms are more favorable. 

To mitigate defeasance costs there are two risks: Term rates are lower and credit spreads have widened.  The defeasance calculation is based on term rates for the remaining life and the credit spread which remains fixed.  One can hedge against lower term rates, but what about fixing the credit spread?  That is possible, but more complicated because it involves buying a credit derivative. 

The borrower’s reasoning to refinance in the CMBS market was simply to fix the rate and not having to buy an interest rate cap to extend the bridge loan.  In this scenario the credit spread remains the same. It takes careful analysis to tell if the borrower is mitigating risk or adding risk. If you have similar questions, give us a call at (415) 510-2100.

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