Why the Fed is on Hold Through Year End

Running the Numbers: Rates Higher Across the Curve

The yield on the 10-year Treasury note backed off  the psychologically important 5% level, its highest point since August 2007, hovering just below it at 4.90%. We suspect there is some room for long-term yields to hold near these levels – or even rise a bit more from here – as the threat of a wider Middle East war persists amid an uncertain economic backdrop.

For the week:

• 2-year Treasury yield: up 1 basis point to 5.06%
• 5-year Treasury yield: up 4 basis points to 4.84%
• 10-year Treasury yield: up 6 basis points to 4.91%
• 30-year Treasury yield: up 6 basis points to 5.07%
• 1-month Term SOFR: down a half a basis point to 5.32%

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, traded flat at 5.38%. 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 four basis points week-over-week, to 4.89%, reflecting the current view that if the Fed hikes again, it won’t be by much.

How much higher will 1-month SOFR rise? 1-month SOFR, via the SOFR futures markets, and the forward curve it projects to the world, shows that it’s expected to peak at 5.44% late this year or early next, then decline consistently over the next year as the Fed eventually cuts interest rates in H1 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 over the course of last week to levels last seen in early October, but remain at historically high levels. Any sustained fall in rate volatility helps to drive rate cap costs lower. 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 mixed earnings news. The price of a barrel of West Texas Intermediate crude oil fell to $83.89 from above $90 a week ago, while the US dollar and Gold both strengthened.

GDP Boom Unlikely to Last

U.S. economic growth boomed by 4.9% in the quarter ending September, surpassing the consensus estimate of 4.5%. What’s driving the gain? Consumer spending contributed a whopping 2.7% to headline GDP, expanding at a robust 4.0% annualized pace, up from 0.8% previously. A surge in business inventories contributed a massive 1.3%, along with 0.8% growth seen in government spending. It wasn’t all rosy though. Nonresidential business investment fell 0.1% (from 7.4% previously) in the face of a 3.8% reduction in equipment purchases (from +7.7% previously). Core capital investment should continue to decline, with projections for capital spending at their lowest point since June 2020.

Our take: The data implies that the US economy is resilient despite the staggering 5.25% in Fed rate hikes since March 2022. That may indeed be the case for now, but can it last? We’re skeptical given the unpredictable economic climate and the growing belief that consumers are quickly eroding their pandemic-fueled savings and running out of ways to cheaply finance their purchases. Further, the decline in the outlook for business investment tells us that firms will continue to be cautious going forward. We hope we’re wrong, but it’s a potential set up for a short and mild recession in early 2024, and a set up for the Fed to opt against making any change in interest rates this Wednesday as well as at its next meeting in December.

Consumers are Going Nuts, Spending Beyond their Means

In September, personal spending increased by 0.7% from 0.4% in August, far above what was expected. Where are consumers – whose spending is responsible for 70% of all US economic output – getting all that money to spend? It seems that it’s not being driven by their incomes, as personal income increased by only 0.3% during the month, matching estimates. Wages and salaries combined, or aggregate compensation, increased by just 0.4% month over month.

Our take: There are multiple factors that tell us consumers’ robust spending can’t continue. High prices and high and rising interest rates are raising questions about how long this growth can last. It’s likely that the dynamic is putting increasing strain on consumers, particularly those with lower incomes. Looking down the road, the depletion of stimulus-related savings, stricter lending standards and the resumption of student loan repayments should erode living standards further. Given these headwinds, the Fed would be wise to look through the hot economic data and choose to sit on their hands at this week’s Fed meeting.

What to Watch: Fed Will See Through Recent Strong Data and Hold Rates Steady

The week ahead is chock full of important data and critical events. Buckle your seatbelt.

The ongoing bet that the Fed is done hiking interest rates hinges on whether the job market and wage increases cool enough to take the pressure off inflation. The Q3 GDP surge, which was largely expected, didn’t provide much insight into the near-term economic trajectory, and neither will Fed Chair Jerome Powell at this Wednesday’s Fed policy meeting. For the second time in a row, the Fed will keep rates unchanged while continuing to broadcast its tightening bias as it awaits more clarity on the economic outlook.

The data calendar in the coming week will help give them the first bits of clarity they’re seeking, especially data on the jobs market. Although the September jobs report (Friday) and initial jobless claims (Thursday) surprised to the upside last month, there were some signs buried in the data that implied that a cooling trend could be right around the corner. Recent data on jobless claims and the unemployed indicate that people are finding work more slowly, which historically has been a sign of a more sustained increase in unemployment.

It’s likely that the October jobs report – always important as it has the greatest impact on interest rates historically – will show that September’s hiring boom was temporary. Furthermore, since jobs report throughout the year are subject to significant revisions, the unemployment rate, which isn’t ever revised, might offer a more accurate indicator of job market conditions. Crucially, wage growth has remained muted, indicating that the job market’s purported strength has not translated into strong wage and income growth. It tells us that the Fed will likely opt to keep rates steady through year’s end.

We said repeatedly months ago that the Fed will be done hiking when unemployment rises to the point that tips the economy into a recession. The problem is, we won’t know a recession is imminent until we’re in one. One signal that a recession will be upon us soon comes in the form of job seekers taking longer to find jobs, rather than in outright layoffs. This may be happening now, as the number of survey respondents (consumer confidence, Tuesday) saying jobs are plentiful, minus those saying jobs are harder to get, hit a post-pandemic low in August and has remained near that level ever since.

A better indicator of the state of the job market is wage growth. A continued slowdown in both the Fed’s favored Employment Cost Index (Tuesday) – which measures the change in the hourly labor cost to employers over time – and average hourly earnings (part of the nonfarm payrolls data) – will give the Fed further confidence to stand pat on rates.

The US Treasury Department’s announcement of its intentions to sell bonds in the upcoming months at 8:30 a.m. New York time on November 1 is arguably the most significant event of the week. Long-term Treasury yields skyrocketed in August following the announcement by the so-called “quarterly refunding” that bond sales by the Treasury would scale up for the first time in more than two years.

Treasury Secretary Janet Yellen has refuted rumors that the US Treasury’s need to fund the growing deficit – which more than doubled to almost $2 trillion in the fiscal year ending in September – is the driving force behind high and rising long term Treasury yields. Investors, however, are skeptical; some interpret it as a warning that the market will soon begin demanding greater penalties – in the form of even higher long-term yields – for the country’s financial mismanagement.

Finally, outside of the data calendar and the Fed decision, market attention will also be focused on Saturday’s escalation of the Israel-Hamas conflict into a ground war, even as concerns about the course of monetary and fiscal policy have largely overshadowed safe-haven flows into Treasuries in recent weeks.

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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