What Fed Will Do If US Defaults
What You Missed
Last week was dominated by concerns over the debt ceiling, but persistent inflation, robust consumer spending data, and strengthening manufacturing indices pushed markets toward the view that interest rates will stay higher-for-longer, steadily eroding away the belief that Fed rate cuts are right around the corner. Prior to entering its blackout period before the June 13–14 FOMC meeting, the Fed will have one last opportunity to evaluate the economy with the release of this week’s jobs data. We’re still counting on the Fed to pause rate hikes this month, assuming the debt-ceiling saga has a messy ending.
Running the Numbers: Rates Rose as Volatility Stayed Rangebound
Rates across the maturity spectrum lurched higher again 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 and 10-year Treasury yields rose a respective 23, 13, and 5 basis points – the 30-year fell five basis points – giving us all a preview of how rates will move – much higher – in the event of a US debt default. The jump in short-term yields maintained pressure in the 2s-10s yield spread, a widely watched barometer of recession potential, to trade at -81 basis points, less than half of its most inverted level (-108) of a couple of months ago. Interest rate 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 5.28%. 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 35 basis points week over week, to 4.12%, reflecting the ongoing 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 scaled back their prediction of rate cuts by the end of this year, now pricing around 30 basis points in rate cuts – back from 60 basis points this time last week – 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, rose markedly near the end of last week due to the ongoing debt ceiling turmoil. Elsewhere, equities were slightly lower on the week. The price of a barrel of West Texas Intermediate crude oil remained steady at $72.75, 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.
Latest Inflation Gauges Ensure Rates Will Stay Higher for Longer
Any possibility of relief from the unrelenting inflation pressures we’re all feeling was shattered by upside shocks in the headline and core PCE price gauges last week, showing why the smothering of inflation remains at the very top of the Fed’s to-do list.
The PCE deflator – a closely watched measure of inflation based on changes in personal consumption, the largest component of Gross Domestic Product – jumped 0.4% in April following March’s 0.1% print, above consensus expectation of 0.3%. The core PCE deflator, a gauge closely monitored by the Fed that excludes volatile food and energy prices, ticked up 0.4% from a 0.3% rise in March, higher than expected. Year-over-year, the PCE deflator rose 4.4%, while the core PCE deflator rose 4.7%.
As experts try to explain how to square recession predictions with solid spending by consumers, attention has once again turned to estimates of just how much households now hold in excess savings. Taking a step back to observe all the consumer data, it Implies that excess savings have become less influential in consumers spending habits. Rather, consumers have become more discerning in their spending, implying that there may not be a long runway of excess spending ahead of us that the Fed will have to contend with via rate hikes. Time will tell. At this point, it is clear that households aren’t simply drawing down some stock of extra cash to fuel their spending; saving rates are rising and consumers are relying more and more on borrowing to finance their consumption.
Our take: Why all the focus on the spending habits of the US consumer? They drive 70% of all US economic activity. To the Fed’s dismay, after 500 basis points in rate hikes, US households still have a voracious appetite to spend money on durable goods and services, and therefore, keep inflation pressures high. Real spending, which adjusts for inflation, grew by 0.5% month over month, showing the difficulty that the Fed faces in quelling households’ spending as it combats inflation.
As the jobs market cools and the risks to the economy’s outlook increase, we suspect that consumer’s spending growth will continue to decelerate, and personal saving rates will rise, giving the Fed confidence to pause rate hikes, but also be forced to keep interest rates high as inflation pressures persist.
Debt Ceiling Saga Roiling Short Term Interest Rates
Interest rates for Treasury bills maturing around the anticipated June 5 “x-date” – the day the US Treasury will reportedly run out of cash and not be able to pay its bills – skyrocketed mid-week. Yields on bills maturing around the X-date traded approximately 100 basis points higher than they were early in the week. Fortunately, Treasury bill yields began to decline toward the end of the week due to reports of progress in negotiations between President Biden and Speaker McCarthy. Why you should care: The dynamic in ultra-short-term yields is just a preview of what’s likely to occur in other bond maturities should the powers that be push us all closer and closer to the default cliff. Buckle your seatbelt.
Fed Meeting Minutes Show the Fed Leaning Toward a Pause
The minutes from the Fed’s May 3rd policy meeting, released last week, demonstrate that committee members’ confidence in their economic and policy outlooks is eroding. The minutes clarify why the Fed’s meeting statement suggested it could be reasonable to pause hiking rates at its June meeting, given that the debt ceiling is front-and-center on the Fed’s mind and over concerns about how much the banking system will contribute to tighter financial conditions for consumers and businesses.
The minutes also showed that the commercial real estate industry loomed prominently in the minds of Fed voting members, who highlighted that the industry was susceptible to sharp price declines. Losses for commercial real estate debt holders, according to the Fed staff, may be “moderate” overall, but they might send additional ripples through the banking system and the market for CMBS.
But since the May 3rd meeting, several prominent Fed members have adopted a more aggressive stance toward rate hikes, prompting many in markets – and the SOFR forward curve – to ease off their expectations of a series of Fed rate cuts before the end of the year.
What to Watch: Debt Ceiling Negotiations to Steal the Show – Again
The debt-ceiling impasse is on everyone’s mind as we come back to work from the long weekend. As of this writing, President Biden and Speaker McCarthy have not reached an agreement, but many anticipate that they will do so later in the week. Politicians are under increasing pressure to find a solution since there is less than $50 billion in the Treasury General Account as of May 24, and the bond market is demanding an escalating risk premium on Treasury Bills, noted above.
The Fed’s also intently focused on the debt ceiling saga. The risk of a downgrade for US government debt brings back memories of the 2011 impasse and the subsequent stricter credit terms for the private sector, even after an agreement had been reached. May’s jobs report (Friday) will be the Fed’s last chance to assess the health of the economy before it meets on June 14th.
Though it is happening too slowly to reassure the Fed, the jobs market is still showing signs of cooling. With job openings (JOLTS, Wednesday) declining from a record high of 12 million, established in March 2022, most of the cooling has been caused by a fall in excess demand. However, there are indications that through April and May, the rate of cooling has slowed.
If the debt-ceiling stalemate hadn’t created such uncertainty, the most recent inflation and spending data probably would have convinced the Fed to hike interest rates on June 14th. However, the debt ceiling cloud will likely prompt the Fed to skip a hike at its upcoming meeting and hold the Fed Funds rate at its current 5.25% level, before considering another hike at its July 26th policy meeting.
How Will the Fed React to a US Default?
A US government default cannot be ruled out given the lack of progress on a debt-ceiling agreement and the approaching X-date. In the worst-case scenario, financial instability might be released upon the world stage. Or perhaps the Fed could step in to save the day?
Fed Chair Jerome Powell has recently played down expectations of a Fed intervention. However, discussions that took place behind closed doors during the debt-ceiling standoffs in 2011 and 2013 show that the central bank was prepared to go to considerable lengths to avoid a financial crisis.
In the worst-case situation, Fed officials were prepared to take “loathsome” options back in 2011, such as buying defaulting Treasury bonds, even at the risk of appearing to be monetizing public debt.
Here’s a quick peek at the Fed’s plan if the US defaults:
- First, how defaulted Treasury bonds are handled. The Fed would likely continue to accept defaulted Treasury securities as collateral in operations such as outright purchases, rollovers, securities lending, repos, and discount-window lending. Treasuries that had defaulted would be valued at market prices, which would result in losses. Back in 2011, Fed officials were worried about acting as, or even being seen as, a market maker for Treasuries that had defaulted.
- Second, the Fed would be quick to address stresses in the repo market. Extreme fluctuations in the demand for and supply of Treasury bills led to rapid changes in repo rates in the time periods surrounding the 2011 and 2013 X-dates. The repo market’s functionality, which is a crucial component of the financial system, was impaired. Most Fed members then concurred to grant the Fed Chair discretion to instruct the New York Desk to execute reverse repurchase operations in the event that bill rates turned negative or repo rates jumped.
- Third, the Fed would seek to help money-market funds that are experiencing large outflows. Both the 2011 and 2013 debt ceiling incidents saw significant money-market fund withdrawals, which caused many funds to reduce their holdings of Treasury notes, increasing their yield. The Fed was concerned that this may increase the likelihood of a failed Treasury auction, which would be disastrous since it would deny the US government access to the market and prevent the Treasury from rolling over its maturing bonds. To remedy the situation, the Fed would likely buy Treasury notes directly. However, there were also worries that Treasury bill purchases would be seen as quantitative easing and lead to accusations that the Fed was monetizing public debt.
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