Why Your March Rate Cut Call is Looking Shaky

What You Missed

Happy New Year! During our last time together in mid-December, dear reader, we were in the midst of a pivot party, where the Fed revealed that it’s finally officially considering rate cuts, igniting an explosive financial market rally, driving short-term Treasury yields down to levels last seen in June. Back then, financial markets expected the first rate cut as soon as March, and nearly 160 basis points of rate cuts over the course of 2024.

Things have changed a bit since then, with many of the most ardent proponents of near-term Fed rate cuts suffering from a hangover as economic data forces them to reel in their euphoria. We agree that rate cuts are coming but still expect the first to occur a little later – in May – and that most of next year’s cuts will come in the second half of the year as the Fed takes its time amid a resilient US economy.

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Extending or Replacing Your Rate Cap? A Few Things to Keep in Mind

  • In general, rate cap costs are down 25-30% from their peak.
  • If your cap is in-the -money, where its strike is below SOFR’s current level, expect your lender to require the same in-the-money strike on the extension/replacement rate cap, regardless of how the asset is performing. Hoping for a much higher/cheaper strike? Good luck with that outside of a formal refinancing of the loan.
  • Balance sheet lenders are more flexible in rate cap negotiations, CLO funded lenders, much less so.
  • We are routinely seeing lenders allow for the term of the rate cap extension to be much shorter than what is written in the loan agreement, e.g., a 90-day extension versus 1-year, saving the borrower money. Why? Given the broad expectation for lower rates, they’re more comfortable, however, in all cases, the borrower will have to continue to roll the cap every 90 days.
  • On a construction to mini-perm bridge loan, make sure to work with the lender to allow for the rate cap’s notional amount to sync with the anticipated draw schedule (an “accreting rate cap”). Why pay for insurance you don’t need?

Running the Numbers: Rates Higher as Data Puts Extreme Rate Cut Bets in Spotlight

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Murky economic data has dragged Treasury yields higher across the board, with all maturities now well off the lows seen in late December after the Fed’s implied pivot to rate cuts. Despite the haze, traders are unfazed, hanging on to their bets for near-term rate cuts, and in doing so, making sure that Treasury yields won’t approach their peaks seen in November anytime soon.  Those bets will be tested though, and soon, with the week’s calendar of key economic data providing more insight into whether the Fed will really cut as soon as March as markets expect. What’s most at risk? The 2-year Treasury yield, as it’s impacted the most of any Treasury maturity to changes in sentiment about what the Fed will do. The 2-year Treasury yield is also a big driver of rate cap costs, making its moves very relevant to borrowers eyeing the extension/replacement of their rate cap.

For the week:

2-year Treasury yield: up 7 basis points to 4.39%

5-year Treasury yield: up 11 basis points to 4.01%

10-year Treasury yield: up 13 basis points to 4.05%

30-year Treasury yield: up 15 basis points to 4.22%

1-month Term SOFR: down 1 basis point to 5.34% (SOFR won’t move markedly lower until we’re closer to a Fed cut, as it reflects the market’s forecast for rates 30 days out.)

Where will SOFR be a year from now? 3-month (CME) Term SOFR, a more useful gauge of hedging costs than 1-month Term SOFR, held steady at 5.37%. 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 to be a year from now, rose twenty-three basis points week-over-week, to 3.65%, reflecting the erosion in conviction of near-term rate cuts bets.

How much higher will SOFR rise? 1-month SOFR, via the SOFR forward curve, implies that one-month SOFR has peaked near 5.34%, and will decline precipitously over the next year as the Fed eventually cuts interest rates several times throughout 2024. The forward curve projects that 1-month Term SOFR will steadily decline from here on out, eventually bottoming out near 3.26% in March 2026.

When will rate cap costs decline? Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, fell week over week, despite the large move in short-term Treasury yields, e.g., the 2-year Treasury. While rate volatility moved lower, it’s still high historically. Yes, rate cap costs would seem to logically decline as lower rates show up but remember those price declines will be neutralized somewhat by bouts of higher rate volatility as we travel down the road toward the first Fed rate cut. Curious what a rate cap costs? Check out our rate cap calculator.

Elsewhere, fell during the week as investors pared back bets that developed market central banks will begin trimming interest rates in the first quarter.  The price of a barrel of West Texas Intermediate crude oil rose slightly, rising  $0.37 from last week to $70.78, as the US dollar strengthened, and Gold weakened slightly, remaining near a record high.

Blowout jobs report pushes back on need for near-term rate cuts…or does it?

Last Friday’s jobs report – always important for interest rates – showed headline nonfarm payrolls increased by 216k in December, surpassing the consensus estimate of 175k. This is in sharp contrast to a downwardly revised gain of 173k in November. The net revision for the two months was -71k.

That’s about where the good vibes end. The household survey (Curious why there are two job surveys?) showed a significantly weaker jobs market, with employment falling by 683k, compared to a prior increase of + 586k. After being converted to the headline jobs methodology, household employment decreased by 753k (compared to + 417k previously), its biggest decline since April 2020.

December’s hourly wage growth was 0.4%, exceeding the 0.3% consensus estimate. Hourly wages increased 4.1% annually (up slightly from 4.0% previously). December’s unemployment rate remained stable at 3.7%, despite a significant decline in the labor force (-676k) and an increase in the number of unemployed persons (+6k). The number of employed workers decreased by 683k (compared to + 586k previously), the biggest decline since April 2020.

Bottom line? There are two radically different depictions of the job market in the December jobs report. The difference between the headline jobs gain and the change in adjusted household employment is nearly one million, the largest gap since September 2020.  The billion-dollar question: Is it wiser to believe the upbeat forecast provided by the headline number or the bleak household survey?

While it’s debatable, the household survey likely provides a more meaningful signal of turning points in the job market, even though the headline number becomes the most reliable gauge of the two over a long period of time. When combined with other aspects of the jobs report – things like the duration of unemployment (longer), demand for temp workers (higher), number of part time workers (higher) and number of hours worked (lower) – the data tells us that the threat of a short recession is still alive, but things aren’t so bad to justify a rate cut in March. As such, we still expect the first rate cut to happen in May, not March.

Services Gauge Backs Up Claims of Economic Slowing

Consumer’s spending on services, as opposed to goods, comprises most of their spending activity. And since we all know that consumer’s total spending makes up roughly 75% of all US economic activity, any gauge of services spending is worth paying attention to.

The Institute for Supply Management’s (ISM) Services gauge for December – the most widely revered metric – supports our view that early indicators of a slowdown in economic activity are showing up.

In December, the ISM index dropped to 50.6 from 52.7, below the consensus estimate of a much milder decline to 52.5. Any reading above 50 indicates growth in the sector.

Despite the relatively stable business environment, services activity slowed more than anticipated due to a decline in new orders and a slowdown in hiring in the services sector. Parts of the data showed that businesses are becoming hesitant to commit to building up year-end inventories due to growing uncertainties in the outlook for demand.

Specifically, inventory levels also dropped 5.8 points to 49.6, returning to contractionary territory, while new orders, a leading indicator of business demand, dropped 2.7 points to 52.8 (from 55.5 in the previous two months).

Our take: Although it is still expanding, barely, the US services sector is clearly expanding at a much slower rate. Businesses are modifying their hiring and inventory strategies in anticipation of softer demand as the demand outlook is increasingly murky. While a trend can’t be established from one month’s worth of data, should the slowing momentum build, the Fed will undoubtedly respond. Something to keep an eye on.

What to Watch: The Last Mile of Fed’s Inflation Killing Quest to Prove Troublesome

If one digs into the details of the December jobs report and ISM Services survey, it becomes evident that the job market could be sending some unnerving signals, if not implying overt signs of recession. Taken together, the state of the jobs market may be worse than it was during the depths of the 2001 recession. Weekly jobless claims data (released Thursday) will gain heightened importance over the coming weeks as a vehicle to prove or dis-prove the eroding jobs picture, especially given the fact that many businesses lay off temporary holiday works about this time of year.

Simultaneously, the December jobs report indicated a sharp rise in wages, offsetting fewer hours worked. This appears to reflect recent wage agreements between employers and unions. Throw in the fact that many state-mandated increases in the minimum wage are taking effect and you have a scenario where the Fed – using its traditional methodology – will likely have a tougher time bringing inflation (CPI, also Thursday) officially down to its 2% target.

But wait a minute. If the jobs market is weakening, how could wages be rising? Minimum wage increases put businesses in a position of either 1) passing those higher costs on to consumers in the form of higher prices – complicating the Fed’s inflation fight, and forcing them to keep rates higher for longer, or 2) Resort to layoffs to reduce costs, as they see themselves no longer able to pass those higher costs along to consumers as they did during the pandemic. In either case, it’s yet to be seen, which tells us the Fed will take its time before launching into the first rate cut. Perhaps the market’s call for a March cut is a bit too soon.

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