Waiting for Next Domino to Fall
What You Missed
This past week perfectly captured the Fed’s predicament: While the ongoing troubles in the banking system imply that the Fed has already gone too far by hiking interest rates ten times over the past year, steering us all toward a recessionary cliff, the jobs market tells a different story. It’s softening too slowly to quell inflation – it’s not even really softening yet – highlighting the need for interest rates to stay high or even go higher than they are now.
We suspect that the current conflict between economic fundamentals and market sentiment will prod the Fed to hold interest rates higher for much longer than markets expect. As for interest rate cuts, it’s likely the Fed won’t cut interest rates until late this year at the soonest amid ever-present inflation pressures and a mild recession that begins in the second half of 2023.
Running the Numbers: Rates Fell and Volatility Stalled
Rates across the maturity spectrum fell last week, as the crosscurrents of a persistently robust jobs market and banking stress kept markets guessing. For the week, the 2, 5, 10 and 30-year Treasury yields fell a respective 15, 14, 5 and 1 basis points. The fall in short-term yields released some pressure in the 2s-10s yield spread, a widely watched barometer of looming recession, to trade at -48 basis points, well off its 40-year high (-108) from a couple of months ago. Swap rates on 3-, 5-, and 10- year maturities continue to trade at least ~55 basis points below their Q1 cycle highs, meaning fixed rate financing, if available, remains on discount.
3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, fell two basis points in the week to 5.07%, still shy of its all-time high near 5.12% hit back on March 10th. 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, fell a whopping 34 basis points week over week, to 3.37%, implying that markets suspect the Fed is done hiking and will begin rate cuts soon.
The SOFR futures market projects that 3-month SOFR will peak at 5.06% sometime in June, then decline over the next year as the Fed eventually eases. Swaps markets are pricing around 50 basis points in rate cuts before the end of the year, implying a credit contraction or recession will start to bite over the summer.
Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, treaded water despite the ongoing turmoil in the banking sector, it now trades at levels seen in early March before the failure of Silicon Valley Bank. Elsewhere, global equities finished down for the week amid renewed jitters in the banking sector. The price of a barrel of West Texas Intermediate crude oil fell $3.50 to $71.50, while the US Dollar weakened, and gold 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.**
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.
Fed Hikes Rates Again, But Implies a Pause
Fed policy makers have always had to operate in a fog of uncertainty. The current outlook is as murky as ever, highlighting risks for the Fed in both directions: Jerome Powell’s Fed would be blamed for killing the economy if interest rates rise too high or stay restrictive for too long. It’s a scenario that reminds us that they run the risk of repeating the errors of Arthur Burns, the Fed Chair who failed to control inflation in the 1970s, by making too many cuts too soon.
In a widely expected move, the Fed hiked the target rate by 25 basis points last Wednesday, increasing the Fed Funds target range to 5.0%-5.25%, while signaling that it was their last hike for a while. Fed Chair Powell pushed back against market expectations of rate cuts this year in the press conference following the meeting by stating that he and other members anticipate core inflation to decline only gradually.
Our take: Still think the Fed will cut interest rates this year? That view is increasingly becoming a tough sell. Should inflation continue to decline very slowly, kept in that state by a still robust jobs market, we suspect the Fed will avoid rate cuts, keeping interest rates high through 1Q24. Looking to the near term, the Fed will feel confident to take a break from hiking at its next policy meeting in June, when the jobs market should be clearly showing signs of softening and strains in the banking system are seen to have tightened the availability of credit.
Now that a pause in hikes is being increasingly accepted, the challenge for the Fed going forward will be to persuade financial markets that a pause in rate hikes won’t be quickly followed by rate cuts. If the Fed can avoid rate cuts until 2Q24, it will likely have a similar effect on the market and economy as if it had hiked rates one or two more times than it has.
Jobs Market Gives Fed Reason to Pause
Last Friday’s release of the jobs report for April showed that 253k jobs were created in the month (up from a downwardly revised 165k in March), exceeding expectations. The labor force decreased by 43k, while the participation rate remained at 62.6%. The decrease in the supply of workers drove a decline in the unemployment rate to 3.4% (from 3.5% previously), matching the cyclical low reached back in January, and the same level as it was before the Fed started hiking rates. Go figure. A corresponding survey of households exhibited a weaker picture, where employment increased by 139k (vs. 577k prior).
Consistent with a firmly growing jobs market and a shrinking labor force, the growth of average hourly earnings (aka wages) accelerated in April, reaching 0.5% month over month from 0.3% the previous month, the fastest rate since last July. The rapid growth is consistent with more trustworthy wage indicators like the Atlanta Fed Wage Growth Tracker, unit labor costs, and the Employment Cost Index (ECI – released two weeks ago), which all show that wage growth picked up in the first quarter and is currently running at an annualized rate of between 4% and 6%.
Bored by all the data? Be careful. The monthly jobs report is historically the single most impactful piece of economic data on interest rates. And recent data on wages is front and center in the Fed’s mind as the pace of wage growth is inconsistent with its 2% inflation target. After all, if consumers have more money to spend, they likely will, keeping demand and prices high for all those shiny things we all know and love, and by extension, keeps the Fed’s finger on the rate hiking trigger.
Our take: While the jobs report’s “strength” was cheered by financial markets, it isn’t as rosy as it seems. The downward revisions to earlier months’ jobs reports (March’s was revised down by 165k jobs) and the household survey’s weaker result indicate that the jobs market may not be as robust as the headline number suggests.
Although the Fed will be concerned by the seeming robustness of the jobs market, it won’t be enough to force another rate hike in June. The Fed’s big fear now is tightening credit conditions, stemming from the mini-banking crisis we’re all living through. Should credit conditions continue to tighten, they will eventually cool the labor market, and therefore do the Fed’s job for it, further supporting calls for a pause.
Markets Waiting for Next Bank Domino
Another justification for a protracted pause while the Fed assesses the impact of its cumulative tightening to date is the resurgent banking turmoil. After the First Republic Bank failure early last week, focus has now shifted toward which large regional banks might pose new dangers. Worries about PacWest Bancorp and Western Alliance Bancorp caused bank stock prices to drop, further raising hopes for rate cuts before the end of the year. Is the banking crisis over? Probably not.
What to Watch This Week: Inflation Data and Credit Pulse on Tap
At last week’s Fed policy meeting, Chair Jerome Powell said that while rates may already be “sufficiently restrictive,” he needs more time to watch developments to be confident in that assessment. Unfortunately for him, both the Consumer Price Index (CPI) and Producer Price Index (PPI) readings for April (Wednesday and Thursday, respectively) will likely show that inflation is still accelerating despite all the Fed’s efforts.
However, some of the acceleration is probably temporary. Oil prices have fallen to date in May after being driven higher in April by OPEC+ production cuts. As a result, it is likely that the increase in April’s headline inflation will be reversed in May. We won’t know until mid-June however, when May’s CPI reading is released. Regardless of what this week’s inflation data implies, the Fed views incoming data with less urgency now than they did last year, as its 500 basis points in rate hikes provide comfort that they’ll do their job at slowing this down – eventually. While the April CPI report won’t provide much comfort that the inflation picture is improving, it also won’t prompt the Fed officials to react, as the deflationary effect of the tightened credit conditions just hasn’t shown up yet.
Probably the most anticipated release of this week is the quarterly Senior Loan Officer Opinion Survey (SLOOS) from the Fed (Monday). It’s a poll of up to 80 large domestic banks and 24 branches of international banks, that gives markets a sense of lenders’ appetite to lend in the current environment, and by extension, a more accurate picture of inflation going forward. We anticipate the survey to demonstrate that lending standards tightened further in Q1. The SLOOS data, which typically anticipates actual lending by a year, will point to a more pronounced slowdown or even a decline in lending in the second half of the year, adding to the economic headwinds we’re all experiencing.
Amid all the data, a trifeca of events lie in wait to trip up the Fed’s inflation fight. First, an impending credit crunch. It is expected to have a particularly negative impact on small businesses and commercial real estate because of the combined effects of Fed tightening and bank failures. Second, a standoff over the debt ceiling in Washington. The partisan impasse is currently coming to a head and threatens a period of severe financial stress. The economic and market impact of a US government default could be comparable to the 2008 financial crisis. Last but not least, El Nino is a climate wildcard. Extreme weather conditions could disrupt commodity supplies, drive up prices, and keep the Fed’s attention on inflation as the weather system intensifies.
Fed Chair Powell and his colleagues might not have much control over the situation if this triple-whammy comes to fruition. Rate cuts are the primary tool for fighting the recession, but it’s difficult for the Fed to use them while it’s still working to get inflation back on target.
Many of our borrower clients have expressed concern about the risk of term rates rising above market expectations when their interest rate cap matures, and how they’ll shoulder the high cost of replacing their rate cap.
Most bridge lenders require the borrower to purchase an interest rate cap to close the loan. A cap’s typical term is 2-3 years. The objective of borrowing at a high credit spread through a bridge lender is to improve the value of the asset, increasing rents or selling the property at a profit. In a low interest rate environment, the economics penciled out.
Less so now. The rise in short-term interest rates has created a significant problem for short-term borrowers. Many borrowers have had to provide more equity to cover the substantial increase in interest rates, anywhere from 0.50% + 5.00%, almost doubling the borrower’s cost of funds.
Once the bridge loan matures the borrower usually has extension options. Some choose to go the route of refinancing via a fixed interest rate term loan via the following types of debt:
Bank – usually fixed with an interest rate swap
One big problem the borrower faces when seeking to refinance into a fixed rate term loan is a rise in fixed rates. Fortunately, there is a way to hedge this risk: a swaption. Don’t let the word scare you. A swaption isn’t as complex as it seems.
Curious? Give us a call to see if a swaption could work for you: 415-510-2100.
Mistakes in financing strategy can be costly down the road, and using an advisor with significant market experience is crucial to guide you through uncharted waters. View an independent study on the topic: Interest rate risk: fixed or floating?
Current Select Interest Rates:
Rate Cap & Swap Pricing:
10-year US Treasury Yield:
Source for all: Bloomberg Professional