Why Your Soft-Landing Hopes Will Soon Evaporate

Running the Numbers: Long-term Rates Rise to Fresh Multi-Decade Highs

Last Wednesday, the yield on the 10-year Treasury note exceeded 4.60%, reaching its highest point since late 2007. Before things began to improve at the end of the week, higher risk-free rates caused 30-year mortgage rates to rise beyond 7.75%, their highest level in roughly 20 years.

For the week:

2-year Treasury yield: down 2 basis points to 5.11%

5-year Treasury yield: up 7 basis points to 4.69%

10-year Treasury yield: up 8 basis points to 4.65%

30-year Treasury yield: up 5 basis points to 4.75%

1-month Term SOFR: up 1 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, fell one basis point to 5.39%. 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 five basis points week-over-week, to 4.98%, reflecting the growing consensus that an eroding US economic picture may be right around the corner.

How much higher will SOFR rise? The SOFR futures market, and the forward curve it projects globally, implies that 3-month SOFR is already near its peak, and forecasts that it will peak in December 2023, at 5.49%, 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 August. 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 in the week as tightening financial conditions undermined stocks early in the week as interest rates, the dollar and commodities all rose.  However, markets stabilized late in the week, buoyed by improved inflation readings in the US and Europe. The price of a barrel of West Texas Intermediate crude oil brushed $95 last Thursday before easing to $90.93, a gain of about $0.95 on the week.

Savings, Incomes, and Inflation Revisions Dent the Case for a Soft Landing

Knowing that consumer spending drives 70% of all US economic activity, we always track the pulse of consumers’ financial health, as it largely determines the near-term direction of America’s economy. Q2 personal spending growth – a gauge for how much excess funds consumers have on hand and their propensity to spend – was revised down from 1.7% to 0.8%, the lowest level since Q1 2022. Included in the data were signs that consumers saved $1.1 trillion less over the past six years than previously thought, roiling estimates of cumulative excess savings and by extension, lowering the probability of a consumer-spending fueled economic soft landing.

On the positive side, after increasing by 0.2% in July, personal incomes increased by 0.4% month over month in August, in line with consensus estimates. A significant part of the rise in income growth was driven by a faster pace of hiring and an increase in the average hours worked. Also released last week, the pace of monthly core inflation – one of the Fed’s favorite inflation gauges – fell to 0.1% in August from 0.2% prior, bringing annual core inflation down to 3.9% from a revised 4.3% in July.

Our take: Softening core inflation and a slowdown in spending growth have rattled the once rock-solid case for a soft landing. Annual revisions to spending and income data suggest that households have saved more money this year and spent less than previously thought. All told, it’s a sign that consumers are becoming more cautious in their spending as they re-evaluate their economic fortunes.

As far as the future direction of interest rates, we give another rate hike this year equal odds as annual inflation runs a little hotter than previously thought while the underlying economic fundamentals are shakier than once assumed and will likely get shakier. Although a government shutdown has been averted for now, the issue will arise again in a month. If the government eventually shuts, and the economic toll of labor strikes keeps rising, there won’t be a need for the Fed to hike rates again.

Why Everyone Believes in a Soft-Landing Before a Recession Hits

Each of the last four recessions were preceded by calls that the economy would experience a soft landing. In hindsight, those calls proved to be misplaced. How could the economic gurus be so wrong?

Remember that recessions are rare, and are defined by non-linear events like a sudden surge in unemployment, a high and lasting spike in oil prices, etc. The reason for economist’s error-prone economic forecasts? It’s their flawed forecasting models – which assume a linear process and normal distribution of outcomes – that often underestimate the likelihood of a recession. Said another way, economic models generally presume that future economic events will be some sort of extension of past ones, or, to use technical terms, a linear process. The problem is, recessions don’t follow a linear pattern.

Since previous recessions caught forecasters off guard, the Fed adds “fan charts” – which place probability bands around a “mean forecast”. Without boring you too much, just know that such models show that the unemployment rate will increase to 3.9% (it’s 3.8% now) by the end of 2023, in line with the widely held belief that there will be a soft landing. The Fed’s own models also show that the risk to the unemployment outlook is asymmetrically biased to the upside, which is one of the reasons why they say that they’re “data dependent” and don’t really know which way the economy is headed but are prepared to act if shaky economic conditions show up in the months ahead.

On the flip side, soft-landing hopefuls point out that housing is reaccelerating, manufacturing is bottoming out, and equities have had a strong year. The problem is that those are the segments of the economy where rate hikes have the fastest real-world impact. For most other segments of the economy, notably the jobs market, it takes 18 to 24 months before the effects of the Fed’s 525 basis points of rate hikes start to bite. Following the Fed’s hiking timeline, that’s late this year or early next. As such, it’s probably premature to assume that a soft-landing is a sure thing.

How 150k UAW Strikers Could Produce 760k in Layoffs

The United Auto Workers (UAW) strike may have a wider impact on the economy that extends well beyond the auto sector. Just thirty-five cents of every dollar of output produced by the motor vehicle industry are directly sourced from within the industry, with fifty-five cents of that output coming from outside sources, and the remaining 10% coming from labor. After accounting for the spillover effects of shuttered auto factories, every UAW striker could result in multiple job losses in employment overall.

How so? The auto industry is renowned for having long supply chains. As such, production disruptions nearly always have a ripple effect outside the industry. For instance, a 54-day walkout by 9,200 General Motors employees in 1998 resulted in the furloughing or layoff of 150k workers nationwide. At the time of this writing, only 25k autoworkers are striking. If the strikes stay at this level, it will knock just 0.01% off annual GDP growth for every week the strike drags on. If the strikes widen to include all 150k UAW workers, the GDP drag would rise to 0.05 percentage points per week. As with previous UAW strikes, a two-month strike would reduce Q4 GDP growth by 0.4%.

The impact on the jobs market will be more noticeable, however. Both the industry that produces motor vehicles and the industries that depend on them are labor-intensive. According to the Bureau of Labor Statistics employment-requirement table, for each auto worker needed to build a car, four other workers outside the auto industry are needed. That’s a factor of five. Let’s hope the strike doesn’t widen or drag on.

What to Watch: Jobs Data to Increase Odds of Recession Before Year’s End

This week’s focus is on the state of America’s jobs market, how its performance will impact the likelihood of a recession before year-end, and by extension, the probability of one more Fed rate hike. Following the brief summer uptick in the leisure and hospitality industries brought on by Taylor Swift and Beyonce’s concert tours, hiring probably declined significantly in September. The always important monthly jobs report (Friday) and August’s JOLTS report (Tuesday) will likely reveal a noticeably softer jobs market beyond even the service sectors. The Fed’s primary indicator of how tight the jobs market is – the ratio of job vacancies to unemployed people – probably weakened to just 1.4.

Remember, all that labor-market cooling occurred in the absence of a UAW auto worker strike. For some perspective, the 1945–1946 UAW strike lasted 113 days. If the strike finally spreads to all UAW members and lengthens, up to 700k jobs may be impacted as explained above. Once the strike is over, the employment damage will be repaired, but the longer it drags on, the more positive economic momentum is lost in terms of missed revenue and economic activity that will never be recouped. We believe the economy has been softening even in the absence of these shocks, and that a short, shallow recession is still likely before the end of the year, making the Fed’s next move a rate cut in Q2 next year.

Strategy Corner: Let’s Talk Interest Rate Swaps

We’ve seen a rise in bank loans for refinancing bridge debt of late.  The large and regional banks offer floating rate loans and swaps to synthetically fix the rate.  The borrower is paying the floating index plus the credit spread on the loan.  The swap, a separate contract from the loan, obligates the borrower to pay a fixed rate and receive the floating index. Simple math, the pay floating and receive floating offset, and the result is the borrower ends up paying a fixed rate plus the credit spread.

Swaps are an ideal way to manage floating rate risk.  A swap can be structured in ways that mitigate risk tailored to the spcific goals and objectives of the borrower.

Important points to consider before executing an interest rate swap:

1)            The bank selling to swap to the borrower earns fee income by adding a spread over the market swap fixed rate.   A swap is an obligation to exchange interest payment streams (pay fix – receive floating) which means there is risk of default.  The bank’s spread is the fee it receives for underwriting the default risk.

2)            Swap spreads almost never correlate to the risk a bank is assuming, and in some cases, the fee income can exceed double-digits.  The bank records the swap fee income on day one, a huge bump to their fee income versus recognizing the fee income over the life of the swap.

3)            Fee income is based upon the Present Value of a 1 basis point change in the swap fixed rate multiplied by the swap spread.  Assume a $25mm, 10-year term/25-year amortizing swap. The market rate is 4.00%, PV01 = $18,230, and the bank spread is 0.25%.  Bank fee income: 25 x $18,230 = $455,750.  All-in fixed rate to the borrower is 4.00% + 0.25% + Credit Spread.

4)            The bank is incented to have the borrower hedge as much of the loan amount as possible and for as long as possible.  Bank swap presentations always include a “non-reliance” disclaimer clause and “strongly recommend” hiring an independent advisor, as the bank clearly states that it isn’t giving the borrower hedging advice, is acting in their own interest, and is not acting as the borrower’s fiduciary.

5)            The swap contact between bank and borrower is called the ISDA Agreement, and is comprised of two parts: the ISDA Master and the ISDA Schedule. The ISDA Master is like the Webster’s dictionary and is standard stuff and never negotiated. The ISDA Schedule is highly customized to the specific borrower and swap, and is the document where the “devil is in the details”.  If you’re a borrower, NEVER sign the ISDA Schedule without having an attorney or advisor review it first.  A non-negotiated ISDA Schedule is always in favor of the bank.

6)            Derivative Logic is an independent, expert hedge advisor that can guide you through the process and provide the education to execute a hedge knowing the proposed structure is suited for a borrower’s particular goals and objectives.

7)            Many borrowers are concerned about introducing an independent derivative advisor to the team because they are worried the bank might push back or closing may be delayed.  If a bank recommends the borrower not hire an attorney that should be a red flag and alarm bells should go off in a borrower’s head.

We have an excellent reputation amongst the banks because we don’t negotiate with a baseball bat.  They know we are team players.

How can Derivative Logic help?

1)            Propose hedging strategies based on the borrower’s goals and risk tolerances.  Fixing all the debt for the entire term of the loan can often lead to adding, rather than reducing, interest rate risk.  We have many stories to share about borrowers going at it alone and ending up with a costly, undesirable outcome.

2)            Swap fee cost savings through effective hedging structures and working with the lender to reduce the swap spread.

There is more to the process and we can provide a proposal of our services and fee structure.  Call us for more information on how we can help.  We also offer an in-person or Video presentation of our Derivatives 101  seminar.

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