Why Higher Inflation Doesn’t Imply Rate Hikes

What You Missed

The data releases and events of the past week served to continue leading markets steadily toward a “rates are going to stay high and be there for longer” outlook amid a mixed economic picture. For every data print that supported hopes for an economic soft landing, another suggests that clouds are gathering on the horizon. As a result, the bond market is on edge as each key piece of economic data is released; traders are parsing each detail to determine if the Fed has finally completed its rate-hiking cycle.  Corporate profits are lagging; labor demand and wage growth are declining; and recurrent downward revisions to the always important monthly job reports tell us that the Fed will hold rates steady at its meeting on September 20th. As for rate cuts, we won’t see the first one until March or April 2024 at the earliest.

Household spending has kept the US economy afloat despite the economic headwinds, but as growth slows, a continued rise in oil and gas prices is poised to squeeze consumer’s spending, potentially triggering a near-term recession.

Curious where rates are headed through year’s end? Join us for our Q4 interest rate forecast webinar on Thursday, October 5th. Email us@derivativelogic.com to sign up and get it on your calendar.

Running the Numbers: Rates Rise Across the Curve Amid Murky Economic Picture

For the week:

2-year Treasury yield: up 4 basis points to 4.99%

5-year Treasury yield: up 5 basis points to 4.42%

10-year Treasury yield: up 3 basis points to 4.29%

30-year Treasury yield: up 5 basis points to 4.34%

1-month Term SOFR: up 1 basis point to 4.37%

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, rose one basis point 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 six basis points week over week, to 4.73%, reflecting the lingering, shaky outlook of whether the Fed has finished hiking.

How much higher will SOFR rise? The SOFR futures market, and the forward curve projects globally, implies that 3-month SOFR is already near its peak, and forecasts that it will peak before year’s end at 5.46%, 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, continues to decline, now sitting at levels last seen in June 2023. 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 lower on the week amid a rise in long-term interest rates and concerns that China may be targeting US technology companies in retaliation for US export bans.  The price of a barrel of West Texas Intermediate crude oil surged to $87.95 from $86.69 a week ago as Saudi Arabia and Russia extended production cuts. The US Dollar weakened, and Gold traded flat.

Yields Make a U-Turn Amid a Flood of New Bond Issuance

Since last Friday’s employment data, the yield on the US 10-year note has increased by more than 20 basis points, peaking at 4.30% on Thursday because of the enormous flood of investment-grade corporate bond issuance that followed Labor Day. New corporate bond supply upwards of $36 billion hit the market last Tuesday alone.

However, this week’s rise in yields, which now hover near their highest levels since the 2008 financial crisis, wasn’t solely influenced by supply. A stronger than anticipated ISM services reading of 54.5,a barometer of the performance of the services side of the economy, where a reading above 50 implies growth. That’s the highest level in six months and higher than the consensus projection, also added to upward rate momentum. Elsewhere, news that Saudi Arabia and Russia will maintain their voluntary oil production cuts through year-end contributed as well, sending Brent crude above $90 a barrel.

Finally, last week’s reading of weekly jobless claims at 216k, the lowest weekly number since February, contradicted the most recent monthly jobs report, kept upward pressure on yields, along with revised upward US budget deficit predictions.

Why you should care: While signals of a softening jobs market fueled hope that the Fed may be finished with its rate hiking campaign, the ongoing stream of mixed economic data has prompted financial markets – via trading in the futures markets specifically – to imply a 42% probability that the Fed will hike rates again in November after holding steady at its September 20th policy meeting.

Fed Officials Hint September Hike is Unlikely

If you listened to speeches of Fed officials last week, you’d be left with the impression that the chances of a rate hike at the next Fed meeting are very low. The New York Fed’s John Williams said last Thursday that he was happy with the current state of monetary policy and that ultimately, economic data will determine if the Fed has hiked rates enough to slay the inflation dragon. Speeches from other Fed officials implied that there was no need to hike rates further at this point, although of course they did not rule out future hikes if deemed necessary. The futures markets reflected this view, assigning only a 7% probability to a September hike and 42% to a November hike.

Takeaways from California Mortgage Banker Association’s 2023 CREF Conference

We went to the conference, so you didn’t have to. Here are our top takeaways:

  • Most attendees we spoke with have dashed their expectations of any near-term Fed rate cuts but are hopeful that rates will stabilize or fall in the early to mid-2024. Despite uncertainties in the commercial real estate sector, participants were optimistic, and the gathering exhibited high energy and hopeful vibes all around.
  • Lenders prefer multi-family, industrial, multi-tenant retail, and hospitality properties. With certain medical office exceptions, many lenders still view office as kryptonite. Lenders are being more selective. Numerous lenders are behind schedule in placing their yearly allocations due to ongoing uncertainty and project stops or pauses.
  • Many attendees are worried about the over $1.3 trillion in commercial mortgages that are due to mature in 2023 and 2024, especially given the high interest rate environment. Fortunately, there is a way to hedge refinance risk – the risk on not knowing what interest rate you’ll end up with when you refi in 6, 9 or 12-months. Reach out to ask us how.
  • Increasing realization that the current rate environment is normal, and that the ultra-low rate environment of the last 15 years was unusual and probably won’t be seen again for a long while.

What to Watch: Inflation to Prove Subdued for Third Consecutive Month

As stated above, Fed officials have gone out of their way in recent days to imply that they’ll hold rates steady this month. This implies that, in contrast to the June Summary of Economic Projections, the Fed committee member no longer believes that another rate hike is necessary, and that the Fed has finshied hiking.

With Fed Funds futures markets – where traders go to put their money where their mouth is regarding their belief in the future direction of interest rates – showing a 42% probability of a November rate hike, markets aren’t totally convinced. The most recent gauge of inflation (Consumer price index aka CPI – this Wednesday) may alter their mindset, as higher energy prices have likely pushed inflation higher, prompting the need, in the eyes of markets at least, for at least one more rate hike.

As for the Fed, it will focus on soft core CPI data, which likely rose just 0.2% for a third straight month, the longest run of weak readings since early 2021, and just what the Fed needs to justify a pause in rate hikes this month.

Some out there remain skittish, believing that the Fed needs to hike rates at least one more time due to still-high headline inflation amid a seemingly resilient economy that’s expanding faster than anyone expected. They’re wrong. The Fed’s own model predicts that rising oil prices – should they stay high – will eventually smother core inflation and slow economic growth. As such, the Fed will probably consider the recent rise in oil prices to be temporary and look beyond it as long as inflation expectations are kept in check (University of Michigan Consumer Sentiment Index, Friday).

But what about all the positive economic data showing gangbusters economic activity this summer? It was likely a fluke. In fact, consumption – the bedrock of US economic performance driven by the almighty US consumer – is likely losing momentum. August retail sales are anticipated to show a decline (Thursday), and industrial production is probably still struggling (Friday). The most likely scenario for the end of 2023? Below trend economic growth and even a short, shallow recession.

Looking to next year, we and markets are actively trying to gauge how soon and how much the Fed will cut interest rates, given the economy’s expected strength and lingering inflation pressures. Futures markets are pricing the Fed Funds rate to end 2024 near 4.4% (it’s 5.50% right now), well above the roughly 2.5% rate that’s viewed as neutral to economic growth.

Looking for greater insight into where rates are headed? Tune in to Derivative Logic’s quarterly interest rate forecast webinar on Thursday, October 5th. Sign up by emailing us@derivativelogic.com.

In the meantime, the bond market has and will continue to contend with a flood of new bond sales from the US Treasury to cover the ballooning federal budget deficit, adding to the upward pressure on long-term Treasury yields. This higher long-term-yield dynamic is amplified by investors who have been selling long-dated bonds, betting that their yields will move back above short-term ones after the Fed eventually shifts toward easing monetary policy in Q2 of 2024.

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