Your Rate Cut Dreams Aren’t Coming True
What You Missed
The flood of economic data last week revealed an unexpectedly strong jobs market while concealing emerging weakness, an emerging trend in a variety of economic indicators. While Congress and the President solved the debt limit “crisis”, the deal increases the odds of a recession without addressing America’s dire fiscal outlook. Elsewhere, a parade of Fed officials signaled they won’t be hiking interest rates when they meet on June 14th. However, given that inflation remains stubbornly high, markets continue to back off their calls for aggressive rate cuts later this year as the Fed maintains its focus on its 2% inflation target.
Running the Numbers: Mixed Bag of Signals
Rates across the maturity spectrum mostly ended the week where they started, recovering from declines mid-week on the back of the seemingly positive jobs data. The crosscurrents of a persistently robust jobs market, stubbornly high inflation, and tightening lending standards continue to dominate. For the week, the 2, 5 10 and 30-year Treasury yields rose a respective 11, 11, 6 and 3 basis points. Pressure persisted in the 2s-10s Treasury yield spread, a widely watched barometer of recession potential, to trade at -81 basis points, in the middle of the recent range of-108 of a couple of months ago and -55 seen a few weeks ago.
3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, fell slightly to 5.25%. The implied yield on the 3-month SOFR futures contract 1-year forward (June ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, rose 7 basis points week over week, to 4.12%, reflecting the ongoing uncertainty surrounding the probability of another Fed rate hike on June 14th.
The SOFR futures market, and the forward curve it projects to the world, implies that 3-month SOFR is already near its peak, and expects it to decline over the next year as the Fed eventually eases. Swap markets once again scaled back their prediction of rate cuts by the end of this year, now pricing around 30 basis points in rate cuts – back from 60 basis points two weeks ago – before the end of the year, suggesting that markets are pricing an economic contraction over the next year as a virtual certainty, with recession risks at their most elevated level since May of 2020. That appears to contradict a lot of what we have recently witnessed. The jump in the riskier sectors of the equities market and the rise in rates tend to point to greater, not lesser, economic optimism.
Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, fell throughout the week on the back of the resolution of the debt ceiling saga. Elsewhere, equities rose markedly in the week. The price of a barrel of West Texas Intermediate crude oil rose to $73.21 as a direct result of Saudi Arabia’s announcement of planned production cuts, while the US Dollar weakened, and gold strengthened.
Borrowers Beware: The LIBOR to SOFR Transition Is Not Your Friend
We’re being flooded with calls and emails from borrowers who were recently informed by their lender that their LIBOR-based, floating rate loan would be converting to a new floating rate index, SOFR. Don’t be fooled, there is nothing standard or routine about transitioning the index in your loan or transitioning the index in your rate cap or interest rate swap.
Confused or uncertain about how the transition will impact you? Give us a call, 415 510-2100, to help guide you through it with as little damage to your bottom line as possible. Make no mistake, making the wrong decision will cost you money.
The Jobs Market Isn’t as Strong as You Think
Far and away the most impactful set of economic data on interest rates – the monthly jobs report – unexpectedly showed strong jobs growth in May, even stronger than the highest forecast. The surprise underscores just how challenging it is to gain a clear picture of the job market these days.
Headline nonfarm payrolls increased by 339k in May (vs. an upwardly revised 294k in April), much higher than the 195k expected. The prior two months’ reports were revised higher by a net gain of 93k jobs. However, the household survey painted a weaker picture, showing a contraction of 310k jobs (vs. 139k prior), as the labor force increased 130k (vs. -43k prior) and the labor-force participation rate stayed at 62.6%. Adjusted to match the nonfarm-payroll methodology, household employment gained 394k (vs. 155k prior).
With household employment contracting by more than the increase in the labor force, the unemployment rate rose to 3.7% (vs. 3.4% prior). Finally, average hourly wages increased by 0.3% month over month, down from the strong 0.4% wage growth seen in April. The weekly average number of hours worked decreased from 34.4 to 34.3. The decrease in hours offset the rise in pay, keeping monthly changes in the average weekly earnings nearly flat. Real hourly wages have declined 0.6% year on year as stubbornly high inflation eats away any growth in consumer wages.
Why all the detail? Well, if you’re reading this, and you borrow money, or serve businesses that do, whether you realize it or not, you’re in the interest rate business. Further, given that full employment is one of the Fed’s two overarching mandates (the other is stable prices), the jobs report is front and center to all of us. Let’s dig in a little more.
You may be asking, why are there two job surveys, the “headline” and “household”?
- The headline survey, also known as the payroll survey, is most well-known for offering an extremely accurate indicator of monthly change in nonfarm payroll employment, with industry and regional specificity. The payroll survey’s statistics are drawn from a representative sample of American businesses.
- The household survey provides a detailed demographic assessment of the civilian, non-institutional population’s labor force. The most well-known statistic of the household survey is the national unemployment rate. The survey also gives a measure of the employed population, which includes self-employed individuals and farm workers.
The U.S. Bureau of Labor Statistics (BLS) conducts the monthly surveys, and feels that they, when analyzed together, provide the most complete picture of the US jobs market. While that sounds good, how can markets and economists be so wrong in forecasting jobs data?
It’s simple: A smaller and smaller number of people and businesses are responding to the BLS’s surveys, skewing the results. At 54.7%, the response rate to the June surveys was the weakest for any May since 2001 and trailed the January-April average of 71%. It’s a scenario where getting a clear reading on the state of the jobs market is becoming increasingly difficult. By extension, it makes the Fed’s job at navigating the interest rate landscape more perilous and error prone.
Bottom line? It’s interesting to note that there is still a sizable gap between household employment, which counts workers, and the payrolls survey, which counts jobs. Since March of last year, more jobs – over 1.2 million more – have been created than new workers. If a growing proportion of people believe they need more than one job to make ends meet, it doesn’t bode well for the economy.
For Fed officials wanting to see a more rapid cooling of the jobs market, the May jobs report did not offer much solace. Fed Chair Powell, New York Fed President John Williams, and Governor Philip Jefferson, the three most influential Fed policymakers, have all expressed a preference to forego hiking interest rates in June. Skipping a rate hike would give the committee time to assess the economic outlook but wouldn’t necessarily mean hikes are finished. Even though Powell believes the economy is weaker than it appears, the debt-ceiling saga was resolved relatively uneventfully, and most recent economic data has surprised to the upside. We continue to expect the Fed to refrain from hiking rates on June 14th.
Everyone Will Learn to Hate the Debt Ceiling Deal
Over the Memorial Day holiday weekend, Democratic and Republican negotiators came to an agreement to increase the debt ceiling until January 1, 2025. The deal’s main component is a cap on spending for 2025 and moderate cuts to non-defense spending in 2024. The savings from this and other components of the agreement total around $1 trillion over the course of ten years, which is far less than the more than $4 trillion that House Republicans sought with the Limit, Save, Grow Act.
Our take: Spending limits for two years will further damage an already fragile economy in the short term. However, they won’t make a dent on the US government debt’s unsustainable medium-term trajectory, which is on course to increase from 97% of GDP in 2022 to more than 130% of GDP by 2033.
Almost everyone anticipates a shallow recession in the second half of the year – if we’re not in one already – because of the Fed’s 500 basis points in rate hikes. The debt ceiling agreement has the potential to prolong and deepen this recession while also making the recovery in 2024 and 2025 sluggish.
What to Watch – Discord Brewing at the Fed
The blowout jobs data for May didn’t sway our belief that the Fed will probably decide against hiking on June 14th, as the more powerful members of the Fed, most notably Fed Chair Jerome Powell, believe that the full impact of recent hikes have yet to been felt, and will lead the economy to deteriorate further in the months to come.
However, remember that Fed decisions are the consensus of a committee, and not the decision of just one person. As such, Chair Powell might experience a FOMC backlash. Several Fed committee members, notably Jim Bullard of the St. Louis Federal Reserve, Michelle Bowman of the Federal Reserve, Loretta Mester of the Cleveland Federal Reserve, and Lorie Logan of the Dallas Federal Reserve, have recently advocated for continued rate hikes. Logan and Bowman both have voting rights on the Fed committee. Governor Bowman’s dissent would be the first by a Fed governor since 2005. If Logan disagrees as well, it would be an uncommon display of disagreement: Only 14% of the 834 FOMC meetings held since 1936 have included two or more dissenters.
Data in the coming week could create the conditions for such conflict. Initial jobless claims (Thursday) will imply only a slow decline in the labor market, too slow for the Fed’s comfort, and the ISM Services index (Monday) will offer limited evidence that consumer’s voracious appetite for services has yet to be tamed. The Fed’s justification for pausing rate hikes this month has weakened because of the debt ceiling saga resolving without much drama, and the fact that intermeeting data has so far generally surprised to the upside. If the Fed pauses in June, as we expect, it may prove to be a mistake. Time will tell.
We expect the SOFR forward curve to maintain its dramatic inversion through mid-year, but will begin to right-size in Q3, while remaining slightly inverted into next year.
Strategy Corner – Corridors
We’ve received numerous calls from borrowers inquiring about ways to reduce the cost of replacing/extending their rate cap in 12 to 18 months when it’s close to expiring. Usually managing interest rates is unique for most borrowers, however in the current rate environment an opportunity presents itself that may provide the right fit for many. Let’s dig into it.
- Borrower has a loan maturing in 2024 or 2025 with options to extend for one, two or three years. Borrower purchased a rate cap when the loan originally closed.
- Extending the loan is uncertain and bridge financing is expensive. Refinancing depends on the asset’s performance. Will the rate environment favor a floating interest rate or fixed?
- The lender doesn’t require to extend the existing cap or waived having to hedge the loan with a cap. However, the borrower wants interest rate protection. What will be the cost to extend the cap for one, two, or three years?
- The borrower expects to borrow anew in the next couple of years.
- The borrower owns an existing asset that will require additional financing in the next couple of years.
- The borrower has a new proposed project, which will require some form of financing within the next couple of years.
- The borrower has debt now, at a fixed rate, and is considering:
- Refinancing with a floater.
- Selling of the asset, but date of which is uncertain.
- Extending the loan with the current lender but opting for a floating rate because the asset may be sold or would like the flexibility to refinance without being subject to any defeasance or yield maintenance costs.
While each scenario is different, the common concern is where interest rates will be in the future, and how to mitigate the risk and maintain flexibility.
Forward starting interest rate caps with an in the money strike (below where rates are expected to be in the future as defined by the forward curve) are expensive and the economics most likely do not make sense. Rate caps with an out of the money strike (above market expectations) are still expensive, just less so.
An interest rate corridor is a risk mitigation strategy to lower the cost of purchasing an in the money cap by selling a higher strike cap. For example, the hedger buys a cap with a strike of 2.00% effective June 1st, 2024, with a maturity date June 1st, 2027. Simultaneously, the hedger sells a 4.00% cap for the same period. The premium received for the sold 4.00% cap offsets the purchased cap by 30%.
Sounds cool, but what if SOFR rises to 6.00%? The hedger bought a 2.00% cap and sold a 4.00% but has to pay 2.00% (the difference between the two strikes).
Whether or not this strategy works for your specific situation requires some analysis. Trust us when we tell you, it may sound complicated, but really isn’t. Curious? Reach out to us: email@example.com or 415-510-2100.
Current Select Interest Rates:
Rate Cap & Swap Pricing:
10-year US Treasury Yield:
Source for all: Bloomberg Professional