Why Fed Won’t Cut Rates This Year

What You Missed

Data and events over the past week confirmed that there is little reason for the Fed to seriously consider cutting interest rates any time soon, thus cementing the reality that interest rates will stay high for the foreseeable future. Robust spending signaled that consumers remain the key driver of economic growth, as regional business surveys showed that firms are indeed facing higher prices, reinforcing recent readings of stubbornly high inflation.  Topping it all off were comments from a parade of Fed officials stressing patience regarding rate cuts. Hopes for rate cuts this year have totally collapsed, with futures markets now predicting that the first rate cut will come in early 2025. The billion-dollar question now?  Maybe the economy isn’t booming despite higher rates but rather because of them.

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Running the Numbers: Rates Mostly Higher as Hopes of Near-Term Rate Cuts Collapse

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Treasury yields across the curve surged to their highest levels of the year on more signs of a resilient economy,  leading bond traders to push out rate cuts bets to 2025. The latest leg of the surge briefly pushed the two-year Treasury yield above 5% after Fed Chair Powell signaled that the central bank is in no hurry to ease policy, a u-turn from what he expressed back in December.

A two-year Treasury at 5% looks to be the magic number at the moment for traders to pile into short-term Treasury bonds, and if they do, establish a peak in yields, at least in the near term (more buyers of short-term Treasury bonds drive up their price, lowering their yield in the process).

The recent developments highlight a swift change in bond markets, which, just a few months ago, anticipated six quarter-point rate cuts from the Fed beginning in March. Now that we have a second week of Treasury yields tracking notably higher, it has become crystal clear that a 10-year Treasury yield near 4%, economic growth near 3% and a red-hot stock market aren’t compatible with inflation declining to the Fed’s 2% target. That means that Treasury yields will likely need to hold near their recent highs to see core inflation sustainably below 3%.  When it does, the Fed will have a choice: accept inflation levels near 3% as the norm or move back toward rate hikes (yikes) to drag inflation down further.

For the week:

Where will SOFR be a year from now? 3-month (CME) Term SOFR, a valuable gauge for the true cost of interest rate hedging, rose one basis point to 5.32%. The implied yield on the 3-month SOFR futures contract 1-year forward (March ‘25), an estimate of where markets expect 3-month Term SOFR – and by extension, hedging costs –  to be a year from now, rose five basis points week-over-week to 4.77%, reflecting financial markets that have thrown in the towel on hopes for any near-term interest rate cut.

How much higher will SOFR rise? 1-month SOFR, via the SOFR forward curve, implies that one-month SOFR has peaked near 5.33% and will decline precipitously over the next year as the Fed eventually cuts interest rates at least once in 2024. The forward curve projects that 1-month Term SOFR will steadily decline from here on out, eventually bottoming out near 3.90% in July 2028.

Where is the 10-year Treasury yield headed? The 10-year Treasury yield forward curve implies that the yield will bottom out at 4.56% in December 2024 – it’s sitting at 4.64% right now and posted a 4.99% 12-month high back in October –  then stage a slow and steady sequential rise. While forward curves aren’t forecasts – they’ve proven to be a horrible predictor historically – they do give one a peak at the market’s current thinking.

When will rate cap costs decline? Rate volatility, a vital driver of the cost of option-based interest rate hedges like rate caps, declined week over week on mellowing Middle East tensions but is still sitting at a 2-month high. Rate cap costs continue to hover 25-30% below their peaks and will likely continue their downward path as the first Fed rate cut gets closer.

Curious about what a rate cap costs? Check out our rate cap calculator.  The calculator is a valuable tool for providing an estimate, but if the expected start date is a couple of months away or the cap’s notional amount is amortizing/accreting, give us a call, 415-510-2100,  for indicative pricing based upon the specific economics.

Elsewhere, global equities were lower on the week amid heightened geopolitical tensions. The price of a barrel of West Texas Intermediate crude oil fell $2.52 from this time last week to $82.89, as the US dollar and Gold both strengthened, the latter trading near all-time highs.

Consumers Are Driving Growth for Now, Keeping the Fed on the Sidelines

As evidenced by the most recent reading of retail sales, consumers increased their spending in March but remained cautious about making large purchases. Even though nominal incomes are growing steadily, people are still cautious about high interest rates and are careful about what they choose to buy.

Retail sales in March increased by 0.7% versus an upwardly revised 0.9% in the month prior. Markets expected a 0.4% increase. Online retailers played a significant role in driving the headline print as well as the effects of high gasoline prices. Vehicle sales, clothing, and sporting goods had a negative impact. However, increased online spending does not imply consumers are shifting away from purchasing anything outside of essential items.

Our take: As we repeatedly state, consumers are the bedrock of America’s economy, driving around 75% of all US economic activity. Thus, as the consumer goes, the economy goes, and by the looks of it, it is going well, or at least well enough for the Fed to stand pat on interest rates. One metric we track in this regard is wages’ growth relative to inflation. As of March, average hourly earnings are growing at a 4.1% annual clip, which is more than the 3.5% rise in consumer prices seen in the same period. As long as this dynamic exists – wages growing faster than prices at the consumer level – consumers will have an impetus to keep spending.

Fed: Inflation’s Fall Has Stalled; Cuts Will Come Later Than Expected, If at All

In a surprising shift from his previous stance, Powell suggested last Tuesday that the Fed will delay cutting borrowing costs in response to unexpectedly high inflation readings that have now persisted for the last three months straight. This suggests a more cautious approach than his previous inclination towards easing back in December. In reaction, Treasury yields have reached new highs for the year, while the dollar’s value has also increased.

Powell’s recent change in direction poses a dilemma for the central bank chiefs from around the world who are gathering in Washington for the International Monetary Fund and World Bank spring meetings. If central banks such as the European Central Bank, Bank of England, and Reserve Bank of Australia decide to implement easing measures, there is a possibility that their currencies may weaken. This could lead to higher import prices and hinder efforts to reduce inflation. However, failing to provide relief from high interest rates could potentially jeopardize economic growth.

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Our take: Powell’s change in tone tells us that the Fed truly believes that inflation’s decline has stalled despite their valiant efforts. But more importantly, even if inflation does post fresh declines this summer, they probably won’t be enough for the Fed to feel comfortable cutting interest rates, fearing a re-acceleration in inflation in the fall.

The burning question now for all you rate-cut junkies out there? Defining the single factor that could drive the Fed toward cuts despite stubbornly high inflation.  That factor is this: a significant and sustained deterioration in the jobs market, where the unemployment rate jumps to the neighborhood of 4.5% (it’s 3.8% now).  Such a move would probably drive the Fed to cut 0.50% or so within the span of three or four months. However, if the unemployment rate stays at or below 4.0% this year, coupled with inflation well above the Fed’s 2% target, the Fed probably won’t cut at all this year.

Survey of Businesses Implies Sticky Inflation Pressures and Higher For Longer Interest Rates

The April Beige Book  – a compilation of interviews by the 12 regional Federal Reserve banks of local business leaders, economists, and bankers – suggests a potential risk of even higher inflation in the near future, as reported by individuals in certain districts, primarily those in the manufacturing sector.

Out of the 12 districts, economic growth was observed in 10, showing a slight or modest increase compared to the previous report in March. Consumer spending saw only a marginal increase, indicating a decline in discretionary spending. Nine districts observed a gradual rise in employment, while three districts did not experience any change. Price increases – aka inflation pressures –  were relatively small, similar to what was reported in March. It was noted that insurance rates have significantly risen for both businesses and homeowners.

Of note were statements by interviewees that businesses face challenges in passing on increased costs to their customers as customers have become more price-conscious. This has led to lower profit margins. Although most contacts anticipated a gradual rise in inflation, a few expressed concerns about the possibility of inflation rising more than expected.

Our take: The Beige Book was often ignored by financial markets in years past, but it has gained significance of late, as the Fed is seen as relying more and more on anecdotes during times of transition. The Beige Book provides the Fed with those anecdotes and has probably influenced Fed Chair Powell’s decision to delay rate cuts and state such publicly last week.

What to Watch: More Signs of a Resilient US Economy to Keep Fed on the Sidelines

The US economy has defied all expectations thus far this year, proving to be much more resilient in the face of flatlining but still uncomfortably high inflation and an increasingly befuddled Fed.  Inflation (Personal Consumption Expenditures, PCE, Friday) has likely picked up again, and it seems that economic growth (Q1 GDP, Thursday) will be robust at around 3% for Q1.

For more insight into where economic growth stands in real-time, check out the Atlanta Fed’s GDPNow measure, now standing at 2.9%. That’s well above what the Fed considers non-inflationary and implies that we’re firmly in a no-cut scenario at present.

That begs the question: Is the economy booming despite high interest rates or because of them? One school of thought states that the Fed’s decision to hike rates by 5.25% starting in mid-2022 has resulted in increased incomes via things like rising stock markets and better returns earned on savings, contributing to a positive economic growth cycle. Such a belief would advocate for rate cuts to reduce inflation.

An alternative theory suggests that the potential for growth in the US economy is higher now than it was before the pandemic, and the corresponding neutral rate of interest – the level of interest rates that neither stimulates nor suppresses economic growth, aka r-star –  is higher now than it was before the pandemic. Such a belief would advocate that interest rates should be higher than they are now to have a restrictive effect and that the Fed hasn’t yet hiked rates high enough to slow economic growth and tame inflation pressures.

Did Fed Chair Powell make a mistake in implying a pivot toward rate cuts last December? In his defense, it was clear that the economy showed signs of weakness late last year, specifically in the jobs market. The inflation and growth surprise we’re experiencing now is probably an outgrowth of that pivot, and the Fed can reverse its growth-inducing impact by implying that it may have to hike rates again to get the growth impulse and inflation trajectory back on track. Don’t count the scenario out; if inflation’s decline remains stalled, growth remains robust, coupled with an increasingly healthy jobs market, another rate hike – or at least the threat of one – may be just what the economy needs.

Outside of data and events, there will be no commentary from Fed officials this week, as they’re in the required blackout period ahead of their next policy meeting on May 1st.

See You at NAFOA

Derivative Logic is a sponsor at the upcoming Native American Financial Officers Association (NAFOA) in Hollywood, Florida, on April 29th and 30th. Contact us if you would like to meet.

Use of Swaps is on the Rise

We are seeing an uptick in bank balance sheet loans and interest rate swaps to fix the floating rate.  An interest rate swap has more nuances and complexity than interest rate caps.  Give the capital market experts at Derivative Logic a call, 415-510-2100,before entering into a swap or signing the ISDA.

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