When and Why Fed Will Cut Rates

Running the Numbers: Dovish Fed and Disappointing Jobs Drag Yields Lower

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Yields staged a sharp reversal over the course of last week, driven lower via a trio of factors including softer data, a more benign refunding meeting relative to market expectations, and a positioning unwind on the back of the Fed meeting and jobs report. There is room for the fall to extend in the near-term, albeit to a ‘floor’ that is higher than where yields peaked over the summer.

For the week:

2-year Treasury yield: down 15 basis points to 4.88%

5-year Treasury yield: down 27 basis points to 4.55%

10-year Treasury yield: down 29 basis points to 4.61%

30-year Treasury yield: down 25 basis points to 4.80%

1-month Term SOFR: flat at 5.32%

Where will SOFR be a year from now? 3-month (CME) Term SOFR, a useful gauge of hedging costs, fell one basis point to 5.37%. 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, fell eighteen basis points week-over-week, to 4.68%, reflecting the growing view that restrictive longer-term yields may be substituting for additional Fed rate hikes and that the Fed is done hiking.

How much higher will SOFR rise? 1-month SOFR, via the SOFR forward curve, is expected to peak at 5.36% in February 2024, then decline consistently over the next year as the Fed eventually cuts interest rates in late 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, fell last to levels last seen in early October. Any sharp fall in rate volatility, like that seen over the last week, helps to drive rate cap costs higher. Until there are clear signs that the Fed is on a rate cutting tilt, rate cap costs won’t decline precipitously. Curious what a rate cap will cost? Check out our rate cap calculator.

Elsewhere, equities were higher on the week as financial conditions loosened amid expectations that the Fed has reached the end of its hiking cycle. The price of a barrel of West Texas Intermediate crude oil fell $0.89 to $81.41 as the US dollar and Gold both weakened.

The Fed is Ready to Call it Quits on Rate Hikes

In its meeting last Wednesday, the Fed held the fed funds rate at a constant 5.25–5.50% range for the second meeting in a row. While in their post-meeting policy statement the Fed acknowledged the recent uptick in economic activity (e.g., US economic growth was a whopping 4.9% in Q3), it pointed out that the blowout growth may not extend into Q4.

Other points of note from the meeting and Chair Powell’s post-meeting press conference were:

1. The Fed believes financial conditions have tightened, noting specifically that high Treasury yields were likely to weigh further on economic activity.
2. The idea that more rate hikes are needed amid recent strong economic data was repeatedly rejected by the Fed Chair. Notably, he suggested that the September dot plot, which implies one more rate hike this year, is already outdated due to tighter financial conditions. We’ve always been skeptical of the dot plot’s ability to accurately forecast where rates are headed, despite the financial markets attempts at using it as such (Why the Fed’s Dot Plot is Hogwash).
3. It seemed that neither the surprisingly strong Employment Cost Index nor the higher inflation forecasts seen in the University of Michigan consumer confidence survey worried him. He claimed that the Fed’s tracking metrics show that inflation expectations are still firmly anchored. This confidence implies that the Fed is more likely to look through the recent spate of strong economic data and wait out the ambiguities in the economic picture than to intervene prematurely via rate hikes to control inflation.
4. When asked if the Fed still had a “hiking bias,” he remained neutral on the matter.

Bottom line? The Fed’s voting committee – via its post-meeting statement – and the Fed Chair – via his post-meeting press conference – always do their best to strike a balanced tone in their communications. This time was no different, as both hawkish (leaning toward rate hikes) and dovish (leaning towards rate cuts) interpretations were justifiable. However, to our ears, both sounded convincingly dovish. The billion-dollar question now is the timing of the first rate cut.

When the Fed will Cut Rates and Why

Bond investors and interest rate traders are increasingly placing bets that interest rate cuts will begin in June, and that the Fed will have cut rates by nearly 100 basis points by the end of 2024.

This timing presents a challenge to the Fed, who has admitted that Treasury bond yields have risen due to expectations that the Fed’s monetary policy will stay tight, likely helping to cool the economy eventually. As such, it is in the Fed’s best interest to push back against the market’s view of rate cuts for as long as possible, ensuring against an easing in financial conditions too soon.

Think of it this way: If individuals and businesses expect that rate cuts are right around the corner, they change their spending and investing behavior accordingly, nudging the economy toward higher levels of growth and creating upward pressure on inflation. Due to still-high and lingering inflation pressures, that’s the exact opposite of what the Fed wants to see.

Our take: Be careful of buying into the market’s view that the first rate cut will show up in the summer. Throughout this cycle, the market has frequently either priced in rate hikes that quickly proved excessive or jumped the gun and declared an end to rate hikes far too soon. As of now, there are few indications that the US economy is seriously faltering, and inflation – at 3.7% – is still well over the Fed’s 2% target.

However, if economic data continues to sour over the coming months – as we expect – the Fed’s “higher for even longer” stance will become increasingly hard to maintain. In turn, they will eventually pivot to rate cuts, but it’s a high bar for them to make that shift. As for the market’s view that the Fed will have cut by 100 basis points by the end of 2024, we doubt it, as the pain threshold for rate cuts is far higher than it was for rate hikes.  One caveat that may lead to rate cuts sooner in the year? 2024 is a Presidential election year, and the Fed typically tries to avoid rate hikes or cuts during the campaign in fear of being accused of playing politics.  Thus, the Fed may be incented to act earlier in the year, then pause during heat of the campaign.

Worse than Expected Jobs Data Increases Recession Odds

The always-important-for-interest-rates monthly jobs report, released last Friday, gives the Fed the confidence it needs to end its campaign of rate hikes.

October’s headline nonfarm payrolls climbed by 150k, less than the consensus expectation of 180k, and in sharp contrast to September’s downwardly revised gain of 297k. A considerably poorer jobs market was depicted in the household survey (Curious why there are two job surveys?) as employment fell by 348k (compared to +86k previously). When adjusted to the non-farm payroll methodology, household employment increased by 188k (vs. -7k previously).

The unemployment rate increased to 3.9%, up from September’s 3.8%. Average hourly earnings (aka wages) increased at a 0.2% monthly pace in October, below the expected 0.3%. Much of the miss is due to an upward revision of August’s wage data.

For our wonky readers, the national unemployment rate’s three-month moving average (U3) is now 0.42 percentage points higher than its low over the last year. That is large enough to have predicted all 11 recessions since 1950 in an average of three months from their start, using the Sahm Rule . The rule states that the start of a recession is imminent when U3 rises by 0.50% or more relative to its low during the previous 12 months and has a false positive rate of just 1%. While the unemployment rate hasn’t hit the rule’s 0.50% just yet – again, it was 0.42% in October –  if the unemployment rate remains at 3.9% in November and December, the Sahm rule’s 0.50% threshold would be hit in December. Will we soon be in a recession? You can watch the odds real-time here.

Our take: The start of recessions are almost always marked by an outsized jump in the unemployment rate when viewed over a year, and if we use history as our guide, we’re close to being in one. It’s a scenario that gives the Fed confidence in its decision to hold rates steady and likely spells an end to its rate hiking campaign.

What to Watch: All Eyes on the Credit Spigot

We don’t know about you, but we’re nursing whiplash from last week’s deluge of economic data and events. Fortunately, the week ahead is much quieter.

The spotlight will be on Monday’s release of the Senior Loan Officer Opinion Survey (SLOOS), a measure of how loan officers feel about recent and potential policy changes, the standards and terms of bank lending practices, the state of business and household demand for loans, among other topics.

The Fed already had access to the SLOOS data prior to last week’s rate-setting meeting, and the rest of us get access to it this week. That begs the question: Fed officials could have been far more hawkish given the recent, surprise inflation (higher) and economic (better than expected) data preceding the meeting, but they chose to minimize them. How come?

The previous SLOOS, released in July showing appetite for lending in Q2, indicated banks planned to tighten credit in the second half of this year. Perhaps there are even more signs of that in this week’s release. Regardless, we’re still expecting that the summer strength in consumers’ spending came from a drawdown in their savings or outright borrowing. If the SLOOS shows that banks are indeed slowing the credit spigot, then consumers should also logically slow their spending through Q4, taking some of the wind out of inflation pressures, slowing economic growth and giving the Fed all the reason it needs to hold interest rates at its next meeting in December and into 2024.

The first glimpse of such will come via Friday’s University of Michigan consumer sentiment survey, which we expect to show consumer’s view of their financial futures to remain depressed with high inflation and higher costs for interest rate sensitive items eroding living standards.

Outside of data, Fed officials will be on parade all week, touting the message that the Fed is comfortable standing pat on rates, but stands ready to hike them anew should the data warrant it.

Extending a Rate Cap? Smart Borrowers are Doing This Now

A huge dilemma exists for borrowers who financed their asset via a bridge loan, bought a required interest rate cap at a low strike at closing, and are now confronted with the need to extend that rate cap for another year or two.

When rates were ultra-low, a 2.00% cap on $20mm might have cost $50k and many borrowers opted to buy a 2-year cap on a loan with a 3-year term.  The expectation at the time was that the asset would be sold or refinanced early at more favorable terms, or the borrower simply didn’t see the logic in buying a 3-yrear rate cap at loan close. Or – the mostly common occurrence – the borrower never expected they would have to ask for a loan extension. Now, the borrower is faced with the requirement of extending the rate cap, at an eye-watering cost in the hundreds of thousands.

A client called us recently asking how borrowers are dealing with the unexpected costs and whether lenders are willing to accept amendments to the initial rate cap requirements. The first step, and the most important one, is to engage your lender well in advance.  Waiting until the last minute significantly reduces your ability to negotiate.

Using the example above, we can provide the analysis that a 4.00% strike offers approximately the same interest rate protection as a 2.00% strike and does so at a much lower cost.  A 4.00% strike for one-year costs $285,000 and a 2.00% cap costs $700k.  Both strikes synthetically fix the loan. The catch?  In both cases, you are pre-paying interest, and synthetically lowering the interest rate on a loan by buying down the points. The interest expense for each accrual period with a 2.00% cap is going to be lower than a 4.00% strike.  The difference? The cost of extending the rate cap.

Depending on the performance of the asset, some lenders may be amenable to the higher strike once they understand the economics, but they aren’t going to do the analysis for the borrower. Some lenders are willing to waive the cap requirement altogether or even accept an interest reserve fund in lieu of an extended rate cap. Give us a call 415-510-2100 to discuss your particular situation.

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