What Middle East War Means for Interest Rates

Running the Numbers: Long-term Rates Rise to Fresh Multi-Decade Highs

For the week:

2-year Treasury yield: up 12 basis points to 5.09%

5-year Treasury yield: up 10 basis points to 4.72%

10-year Treasury yield: up 7 basis points to 4.71%

30-year Treasury yield: up 4 basis points to 4.87%

1-month Term SOFR: down 2 basis points to 5.33%

Where will SOFR be a year from now? 3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, fell three basis points to 5.40%. The implied yield on the 3-month SOFR futures contract 1-year forward (September ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, rose 17 basis points week-over-week, to 4.92%, reflecting the growing view that rates will stay higher for even longer.

How much higher will SOFR rise? 1-month SOFR, via the SOFR futures markets, and the forward curve they project to the world, is expected to peak at 5.45% in December 2023, then decline consistently over the next year as the Fed eventually cuts interest rates in Q2 2024.

Will rate cap costs ever decline? Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, held steady at levels last seen since May. Any decline in rate volatility helps to drive rate cap costs lower. However, rate volatility is still high historically, and until there are clear signs that the Fed is on a rate cutting tilt, rate cap costs won’t decline precipitously.

Elsewhere, equities were higher on the week. The price of a barrel of West Texas Intermediate crude oil fell over $1 to $87.36 as the US dollar weakened and Gold strengthened.

Sticky Inflation Pushes Rate Cuts Further Out Than You’d Like

Headline CPI grew by 0.4% (up from 0.6% in August), while the rise from the previous year remained at steady 3.7%. Monthly core inflation held at 0.3%, as widely expected; year-over-year, core inflation fell to 4.1% (from 4.3% previously). All told, annualized core inflation – the Fed’s favorite gauge – is at 3.9%, still almost double the Fed’s 2% target.

What’s keeping inflation high?

The services side of the coin was the main driver of higher inflation in September, rising to a strong 0.6% (up from August’s 0.4%). Owners’ equivalent rents (OER) rose substantially to 0.6% (from 0.4% previously), although primary rent inflation stayed at 0.5%. As an aide, we hear a lot of whining from analysts in commercial real estate that OER doesn’t measure what’s really happening with rents and that the Bureau of Labor Statistics (BLS), the government agency that compiles the data, is leading the Fed astray.  While that may indeed be the case, it’s important to remember that OER is a lagging indicator of inflation and will likely begin to reflect flat rent growth as the year comes to a close.

Goods prices fell 0.4% in September (after declining by 0.1% in August) its fourth straight month of declines. The fall was led by an unexpected 2.5% decline in used car prices (down from the previous 1.2% rise), while the inflation rate for new car prices stayed at 0.3%. As the fourth week of the UAW strike approaches, the disruption in auto production may momentarily impede the development of disinflation for new automobiles.

Our take: The inflation picture in September was a mixed bag. Headline inflation fell, but inflation at the core level – what the Fed really focuses on – jumped higher. Prices for goods continue to fall, but prices for services either made a U-turn higher (rents) or continued their trend higher (autos). As such, it’s becoming a close call to speculate that the Fed may just need one more hike under its belt to feel confident that it’s on its way to slaying the inflation dragon. Rents haven’t deflated as much as the goods sector, and other essential service categories are still experiencing significant price increases. While we still believe the Fed is done with rate hikes in the cycle, it’s increasingly becoming a close call. The fly in the merlot? The potential for a widening middle east war.

Scenario Analysis: How Israel-Hamas War Could Impact Interest Rates

Like previous Middle East conflicts, the recent confrontation between Israel and Hamas has the capability to cause significant disruptions to the global economy, potentially leading to a recession if additional countries become involved. Because the Middle East is a vital source of energy and a major shipping route, conflicts there have the potential to rock the entire world. The most obvious example is the 1973 Arab-Israeli “Yom Kippur” War, which resulted in an oil embargo and years of stagflation in industrial economies.

War is never a good idea, and especially so now given the fragility of the global economy. It’s still getting over an inflationary wave that was made worse by Russia’s incursion into Ukraine earlier this year. A new conflict in an area that produces so much energy could easily spark a renewed spike in inflation. Wider ramifications might include a renewed upheaval in the Arab world as well as an even more uncertain US presidential election on the back of much higher gasoline prices, a sensitive dynamic for US consumers, who alone drive 70% of all US economic activity. Where will we end up? No one really knows, but it’s worth taking a peek at a few scenarios on ways it could play out.

Scenario #1: Direct conflict between Israel and Iran.

This time around, should a more severe escalation put Israel in direct confrontation with Iran, oil prices could rise to $140 a barrel or higher, as global growth slumps to nearly 1%, resulting in a recession that would wipe out almost $1 trillion in global economic output. Such a scenario would prompt the Fed to cut interest rates substantially – putting its inflation fight on the back burner – to try to limit the economic fallout on US consumers. Short term interest rates would fall markedly in anticipation of Fed cuts joined by long-term rates, driven lower by a flood of investors seeking safety in long-term Treasury bonds.

Scenario #2: Proxy War

Should the fight spread beyond Israel and Gaza to only Syria and Lebanon, home to strong militias supported by Tehran, but stop short of a direct fighting between Israel and Iran, we’d witness a proxy war.

In this scenario, the global economy is affected by a double whammy of a double-digit increase in the price of oil, combined with a sharp, risk-off move in financial markets, similar to what occurred during the Arab Spring. Together, they would dent global growth slightly, likely somewhat less than what was seen during the global economic downturn in 2009 and the 2020 COVID crisis. The Fed would back off any further rate hikes, and would lean toward rate cuts sooner, with short- and long-term interest rates both falling on similar themes as scenario #1 above, but only less extreme.

Scenario #3: Containment to Israel and Gaza

A potential course for the current crisis could simply be a repetition of 2014’s ground invasion of Gaza that claimed over 2,000 lives when Hamas abducted and killed three Israelis. The conflict remained contained to Palestinian territory and had little effect on oil prices or the world economy.

The difference this time around is increased US sanctions on Iran’s oil sales. With the thawing of relations with the US indicated by prisoner exchanges and asset unfreezing, Tehran has increased its oil output by as much as 700,000 barrels per day this year. Should this scenario come to pass, oil prices might rise only slightly with little impact on the world economy, and particularly so if Saudi Arabia and the United Arab Emirates used their excess capacity to balance any loss of Iranian oil production. Interest rates would continue to follow their current themes – higher for longer rates, eventual Fed cuts amid recession risks – with bouts of volatility in between.

While the magnitude varies, the overall trend in all these scenarios is the same: more inflation, slower growth, and more expensive oil, all factors that play into, at a minimum, a near-term end to Fed rate hikes, with a more focused eye toward interest rate cuts as the Fed seeks to contain the economic fallout.

What to Watch: Focus on the Health of the Consumer

The robust spending habits of the US consumer is one of the few surviving engines of economic growth. But just as another slew of unfavorable shocks are about to hit the economy, consumer spending habits are looking increasingly fragile (retail sales, Tuesday), presenting yet another obstacle to economic growth. Businesses aren’t increasing inventories (also Tuesday) in expectation of stronger demand; rather, inventories are growing because demand is cooling.

There may be new signs of trouble in the housing market, as states in the Sun and Rust belts that contributed to the pandemic’s spike in home prices are seeing an increase in unemployment. Declining rents in those states is an interesting indicator and something to watch. High and rising long-term Treasury yields, a slowdown in hiring combined with increasing layoffs (jobless claims, Thursday) could spur a new wave of declines in home prices (housing starts, Wednesday; existing-home sales, Thursday).

It’s all continued signs of the lagging impacts of the Fed’s massive rate hiking campaign. However, given the numerous unfavorable supply shocks that are probably right around the corner, the Fed will fire up its threats of another hike once again if it believes the geo-political impacts to the economy are brief and that its previous hikes are nearing their full economic impact.  We’ll get a better sense of that on Thursday when Fed Chair Powell speaks publicly. Its will be his first official opportunity to give us all a peek into the Fed’s mind since September’s consumer and producer inflation gauges and the jobs report all surprised to the upside. For now, we’re sticking to our believe that the Fed is done hiking in this cycle.

Strategy Corner: Let’s Talk Interest Rate Swaps

We’ve seen a rise in bank loans for refinancing bridge debt of late.  The large and regional banks offer floating rate loans and swaps to synthetically fix the rate.  The borrower is paying the floating index plus the credit spread on the loan.  The swap, a separate contract from the loan, obligates the borrower to pay a fixed rate and receive the floating index. Simple math, the pay floating and receive floating offset, and the result is the borrower ends up paying a fixed rate plus the credit spread.

Swaps are an ideal way to manage floating rate risk.  A swap can be structured in ways that mitigate risk tailored to the spcific goals and objectives of the borrower.

Important points to consider before executing an interest rate swap:

1)            The bank selling to swap to the borrower earns fee income by adding a spread over the market swap fixed rate.   A swap is an obligation to exchange interest payment streams (pay fix – receive floating) which means there is risk of default.  The bank’s spread is the fee it receives for underwriting the default risk.

2)            Swap spreads almost never correlate to the risk a bank is assuming, and in some cases, the fee income can exceed double-digits.  The bank records the swap fee income on day one, a huge bump to their fee income versus recognizing the fee income over the life of the swap.

3)            Fee income is based upon the Present Value of a 1 basis point change in the swap fixed rate multiplied by the swap spread.  Assume a $25mm, 10-year term/25-year amortizing swap. The market rate is 4.00%, PV01 = $18,230, and the bank spread is 0.25%.  Bank fee income: 25 x $18,230 = $455,750.  All-in fixed rate to the borrower is 4.00% + 0.25% + Credit Spread.

4)            The bank is incented to have the borrower hedge as much of the loan amount as possible and for as long as possible.  Bank swap presentations always include a “non-reliance” disclaimer clause and “strongly recommend” hiring an independent advisor, as the bank clearly states that it isn’t giving the borrower hedging advice, is acting in their own interest, and is not acting as the borrower’s fiduciary.

5)            The swap contact between bank and borrower is called the ISDA Agreement, and is comprised of two parts: the ISDA Master and the ISDA Schedule. The ISDA Master is like the Webster’s dictionary and is standard stuff and never negotiated. The ISDA Schedule is highly customized to the specific borrower and swap, and is the document where the “devil is in the details”.  If you’re a borrower, NEVER sign the ISDA Schedule without having an attorney or advisor review it first.  A non-negotiated ISDA Schedule is always in favor of the bank.

6)            Derivative Logic is an independent, expert hedge advisor that can guide you through the process and provide the education to execute a hedge knowing the proposed structure is suited for a borrower’s particular goals and objectives.

7)            Many borrowers are concerned about introducing an independent derivative advisor to the team because they are worried the bank might push back or closing may be delayed.  If a bank recommends the borrower not hire an attorney that should be a red flag and alarm bells should go off in a borrower’s head.

We have an excellent reputation amongst the banks because we don’t negotiate with a baseball bat.  They know we are team players.

How can Derivative Logic help?

1)            Propose hedging strategies based on the borrower’s goals and risk tolerances.  Fixing all the debt for the entire term of the loan can often lead to adding, rather than reducing, interest rate risk.  We have many stories to share about borrowers going at it alone and ending up with a costly, undesirable outcome.

2)            Swap fee cost savings through effective hedging structures and working with the lender to reduce the swap spread.

There is more to the process and we can provide a proposal of our services and fee structure.  Call us for more information on how we can help.  We also offer an in-person or Video presentation of our Derivatives 101  seminar.

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