What Debt Default Means for Interest Rates
What You Missed
The debt ceiling debate continues to be front-and-center on the minds of markets, keeping everyone guessing as our entrusted politicians can’t seem to come to an agreement. More damage to the economy could result from the current debt ceiling impasse than from previous ones due to the extreme polarization of politics, which led to the Republican side walking out of negotiations last Friday. Another reason is the timing of the early June “x” date – the date when the US Treasury’s “extraordinary measures”, mainly accounting tricks, to keep America’s finances solvent – will be exhausted.
With the economy already susceptible to a recession following 500 basis points of Fed hikes since March 2022, the timing isn’t great. As the debt ceiling debate lingers on, it’s not hard to envision a scenario where the hit to the economy is significant, tipping a mild recession into a deeper downturn. In the meantime, the economic landscape increasingly shows the Fed needs to keep interest rates higher for longer – and avoid rate cuts – to bring inflation sustainably back toward the Fed’s 2% target.
Running the Numbers: Rates Rose as Volatility Stayed Rangebound
Rates across the maturity spectrum lurched higher last week, as twists in the debt limit saga added to the crosscurrents of a persistently robust jobs market, stubbornly high inflation, and tightening lending standards. For the week, the 2, 5, 10 and 30-year Treasury yields rose a respective 29, 28, 19 and 10 basis points. The rise in short-term yields maintained pressure in the 2s-10s yield spread, a widely watched barometer of recession potential, to trade at -61 basis points, less than half of its most inverted level (-108) of a couple of months ago. Swap rates on 3-, 5-, and 10- year maturities continue to trade at least ~50 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, rose to a new all-time high near 5.16%, exceeding its previous high of 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, rose nine basis points week over week, to 5.18%, reflecting the growing uncertainty stemming from the debt ceiling saga.
The SOFR futures market, and the forward curve it projects to the world, implies that 3-month SOFR is already near its peak, and expects it to decline over the next year as the Fed eventually eases. Swap markets are pricing around 60 basis points in rate cuts before the end of the year, implying a credit contraction or recession will start to bite in late summer.
Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, ended up flat during the week, despite the ongoing debt ceiling turmoil. Elsewhere, global equities were marginally higher in the week. The price of a barrel of West Texas Intermediate crude oil was steady at $71.50, while the US Dollar strengthened, and gold weakened.
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.
Interest Rates: Caught in Tug of War Between Fears of Debt Default and More Fed Rate Hikes
Interest rate markets are increasingly torn between two opposing forces: an economy that has proven to be surprisingly resilient and a political impasse in Washington that threatens to deal it a serious blow. Until Friday, when debt-ceiling talks hit a snag, bond traders were firmly focused on the growing risk of still-higher interest rates as data revealed the economy is expanding at a faster-than-expected pace and ongoing warnings from Fed officials that its inflation fight is far from over.
Market confidence that the Fed will cut interest rates this year is slowly starting to erode. The shift in sentiment was evidenced in trading in Fed Funds futures, which showed an increased probability – now 40% – of a quarter-point Fed rate hike at the next policy meeting on June 14th. The move gained momentum from the fitful negotiations in Washington over raising the debt limit. A failure of which would certainly alter the Fed’s interest rate-setting path.
Our take: Will the US default? No. Despite the ongoing incessant news coverage and political drama, there’s zero chance that our beloved politicians will send us off the default cliff. The stakes are simply too high and will hurt everyone. Politicians will find a compromise, but not until the very last minute. They always do. Every. Single. Time.
Once the debt ceiling drama has passed in early June, markets will re-focus on the non-political currents moving markets: a persistently robust jobs market, stubbornly high inflation, and tightening lending standards, which, on-whole will likely require that the Fed avoid cutting interest rates and keep them high through the rest of 2023.
What if the US defaults? Rest assured, it isn’t going to happen, as the US has increased the debt limit 78 times since 1960. It won’t be any different this time around. If the US did default though, confidence in the US financial system would come into serious question, causing the purchasing power of the US dollar to fall precipitously and inflation to rise markedly anew. To continue borrowing, the US Treasury would have to incent purchasers of its bonds over the longer term with much higher rates of return, via higher bond coupons, which would emanate through the financial system. That means higher interest rates for you and me on everything from credit cards, car loans, mortgages, loans from banks and bridge lenders, etc., crashing the economy in the process. Wide scale job losses would ensue. It’s a scenario no one wants, plain and simple.
Consumers Become Increasingly Discerning as the Economy Slows
A highly watched gauge of the appetite for consumer spending – retail sales – suggests consumers are becoming more selective in their spending as the economy slows toward an expected recession later this year.
In April, overall retail sales increased 0.4% after falling 0.7% in March. That was less robust than the consensus estimates of 0.8%. Real retail sales were essentially flat though after adjusting for inflation, with control-group sales rising just 0.3%. Real sales have been edging closer to the pre-pandemic trend, even though nominal sales are still significantly above it.
Fed Official’s Speeches Hint at Growing Internal Discord
Speeches by Fed officials, aka “Fedspeak”, last week indicate growing disagreement over what the Fed should do next. While Cleveland Fed President Loretta Mester, St. Louis Fed President James Bullard, and Dallas Fed President Lorie Logan all suggested the Fed should hike again in June, Fed Chair Jerome Powell indicated he is content with a wait-and-see approach. By the end of last week, markets had priced in fewer rate cuts than they had a week earlier.
Powell’s comments corroborate similar comments given last week by other members of his leadership team, such as Governor Philip Jefferson and New York Fed President John Williams, who was most recently nominated to serve as vice chair pending Senate confirmation.
Our take: Assuming there’s no solvency disaster from the debt ceiling saga, the discord at the Fed tells us that the Fed will officially adopt a “pause” stance in June, giving it time to assess incoming economic data, specifically data on inflation.
What to Watch: Debt Ceiling Negotiations to Steal the Show – Again
If Janet Yellen, the Treasury Secretary, is correct, the US government won’t have enough money to pay its bills as of June 1st – the so-called “X-date”. That is less than two weeks away, and as of this writing, no deal has been made. Financial markets have been oddly placid, in contrast to the period leading up to the 2011 debt-ceiling crisis. Why so calm? They know, like us, that a deal will be reached, just not until the very last minute.
If we – and financial markets – are wrong, expect a big repricing in rate expectations. Even if Speaker McCarthy and President Biden reach a compromise, mishaps could occur under such pressure. If the negotiations run until the last minute – and become so bitter that they undermine rating agencies’ confidence in the US government’s creditworthiness – the resulting financial turmoil could turn what we expect to be a mild recession later this year into a deep and lasting one.
Some others hold out hope that, in the worst-case situation, the Fed will step in to save the day. In the event of a true US default, the Fed can indeed loosen financial conditions to help markets function, but it would want to avoid creating the impression that it is monetizing debt or conducting Quantitative Easing on non-performing Treasury bonds.
During the 2011 debt-ceiling crisis, the president of the St. Louis Fed warned that any indication that the Fed could be inclined to ease the situation through debt monetization could spark inflation expectations and result in a catastrophic end. In such a scenario, expectations of higher inflation would explode, and the crisis might become significantly worse than it would otherwise be.
Even without the threat of a US default, and the Fed’s likely reaction to such, inflation is already too high. The final May reading of the University of Michigan’s long-term inflation expectations (Friday) will determine whether the elevated preliminary reading was an anomaly or not, and the Fed’s preferred inflation measure, the PCE index (also Friday), will show inflation remained stubbornly high over the past month. The Fed’s struggle to balance preserving growth and reining in inflation will be highlighted by the sluggish but steady increase in jobless claims (Thursday) and the slow but steady decline in business investment (durable goods, Friday).
How Could Debt Ceiling Negotiations Play Out?
While there are many ways it could go, we are convinced that Congress won’t let the US Treasury run out of cash – likely on June 8th or 9th – without taking any action. The most likely scenario is a comprehensive agreement with a spending cap and a suspension of the debt ceiling until early 2025. A deal is more likely to be reached later this week or just before the Treasury’s June 8th or 9th deadline.
Although highly unlikely, but still conceivable, a deal may not be reached before the deadline. If that happens, a temporary extension would be the most likely result. If there’s no agreement to extend, the Treasury would have to decide between suspending most payments while servicing the debt or continuing to borrow more than the debt limit to make all scheduled payments.
Strategy Corner – Corridors
We’ve received numerous calls from borrowers inquiring about ways to reduce the cost of replacing/extending their rate cap in 12 to 18 months when it’s close to expiring. Usually managing interest rates is unique for most borrowers, however in the current rate environment an opportunity presents itself that may provide the right fit for many. Let’s dig into it.
- Borrower has a loan maturing in 2024 or 2025 with options to extend for one, two or three years. Borrower purchased a rate cap when the loan originally closed.
- Extending the loan is uncertain and bridge financing is expensive. Refinancing depends on the asset’s performance. Will the rate environment favor a floating interest rate or fixed?
- The lender doesn’t require to extend the existing cap or waived having to hedge the loan with a cap. However, the borrower wants interest rate protection. What will be the cost to extend the cap for one, two, or three years?
- The borrower expects to borrow anew in the next couple of years.
- The borrower owns an existing asset that will require additional financing in the next couple of years.
- The borrower has a new proposed project, which will require some form of financing within the next couple of years.
- The borrower has debt now, at a fixed rate, and is considering:
- Refinancing with a floater.
- Selling of the asset, but date of which is uncertain.
- Extending the loan with the current lender but opting for a floating rate because the asset may be sold or would like the flexibility to refinance without being subject to any defeasance or yield maintenance costs.
While each scenario is different, the common concern is where interest rates will be in the future, and how to mitigate the risk and maintain flexibility.
Forward starting interest rate caps with an in the money strike (below where rates are expected to be in the future as defined by the forward curve) are expensive and the economics most likely do not make sense. Rate caps with an out of the money strike (above market expectations) are still expensive, just less so.
An interest rate corridor is a risk mitigation strategy to lower the cost of purchasing an in the money cap by selling a higher strike cap. For example, the hedger buys a cap with a strike of 2.00% effective June 1st, 2024, with a maturity date June 1st, 2027. Simultaneously, the hedger sells a 4.00% cap for the same period. The premium received for the sold 4.00% cap offsets the purchased cap by 30%.
Sounds cool, but what if SOFR rises to 6.00%? The hedger bought a 2.00% cap and sold a 4.00% but has to pay 2.00% (the difference between the two strikes).
Whether or not this strategy works for your specific situation requires some analysis. Trust us when we tell you, it may sound complicated, but really isn’t. Curious? Reach out to us: email@example.com or 415-510-2100.
Current Select Interest Rates:
Rate Cap & Swap Pricing:
10-year US Treasury Yield:
Source for all: Bloomberg Professional