Your Roadmap to Rate Cuts

What You Missed

Data last week raised hopes for the prospect of an economic soft landing, just in time for the Fed to lend its own opinion on the matter during this Wednesday’s monetary policy meeting. Jobs data for November seemed to paint a picture of strength, showing that once again, high interest rates and falling inflation haven’t led to large increases in unemployment, but rather to lower the number of job openings. Our reading of the data tells us that the jobs market has deteriorated meaningfully, with the growth in jobs residing in just a handful of recession-proof sectors. Couple that with consistently falling inflation and you have a green light for the Fed to pull the trigger on its first rate cut in early Q2 2024.

Are you wondering where are rates headed in 2024? Plan to watch our Q1 2024 Interest Rate Outlook livestream on Wednesday, December 13th at Noon Pacific time.

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Running the Numbers: Mixed Yield Moves Reflecting Mixed Economic Signals

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After last week’s seemingly better-than-expected jobs data, bond traders scaled back their expectations of rate cuts, dragging short-term Treasury yields higher. They now estimate that there is less than a 50% chance that the first rate cut will occur in March, and they are placing their bets on the Fed cutting rates by just over a percentage point in all of 2024. That’s in sharp contrast to the 60% probability of easing beginning in March as projected by traders earlier this month, when they factored in roughly five quarter-point cuts for 2024.

For the week:

2-year Treasury yield: up 12 basis points to 4.76%

5-year Treasury yield: up 7 basis points to 4.28%

10-year Treasury yield: up one basis point to 4.27%

30-year Treasury yield: down 7 basis points to 4.34%

1-month Term SOFR: up 1 basis point to 5.36%

Where will SOFR be a year from now? 3-month (CME) Term SOFR, a useful gauge of hedging costs, rose three basis points to 5.39%. The implied yield on the 3-month SOFR futures contract 1-year forward (December ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, jumped eighteen basis points week-over-week, to 4.27%, hammering home the market view that the Fed is done hiking and will have engaged in a handful rate cuts by this time next year.

How much higher will SOFR rise? 1-month SOFR, via the SOFR forward curve, implies that one-month SOFR has already peaked near 5.35%, and will decline precipitously over the next year as the Fed eventually cuts interest rates several times throughout 2024.

Will rate cap costs ever decline? Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, rose week over week, reflecting the large move in short-term Treasury yields, e.g., the 2-year. While rate volatility moved lower, it’s still high historically. Curious what a rate cap costs? Check out our rate cap calculator.

Elsewhere, equities were modestly lower on the week as expectations of rate cuts dimmed after the firmer jobs data. The price of a barrel of West Texas Intermediate crude oil fell about $1.80 from last week to $71.25, as the US dollar strengthened, and Gold weakened from record highs.

Jobs Report Not as Rosy as it Seems

November saw a 199k increase in nonfarm payrolls (up from 150k in October); however, despite the rosy news headlines, the gains were concentrated in just two recession-resistant sectors – government and healthcare – and helped by the resolution of the recent labor strikes. Expectations of an economic soft landing – where inflation continues to fall amid a tolerable rise in unemployment – were stoked by the unemployment rate falling to 3.7% (from 3.9%) and an increase in average weekly earnings, aka wages, of almost 0.7%.

Our take: The job gains in government and healthcare, which generally aren’t affected by economic cycles, coupled with the 41k one-time gain due to the resolution of the recent worker strikes, accounted for more than 80% of the job gains. That tells us that the rosy job headlines aren’t what they seem, and don’t accurately depict the state of the jobs market.

The unexpected decline in the unemployment rate to 3.7% delayed the triggering of the Sahm rule – an unemployment-based measure that has an excellent record of predicting recessions. If the unemployment rate returns to 3.9% in December and rises to 4.0% in January and February 2024, the rule will be triggered in February. On average, the Sahm Rule calls a recession four months after it began.

Bottom line? The Fed will likely look through the surface-level strength of the jobs data and focus on its progress on inflation. This will allow it to continue to sit on its hands on any change in interest rates this Wednesday, eventually leading it to pull the trigger on the first rate cut sometime in early Q2 next year.

Consumers’ View of Inflation are Just What the Fed Wants

A sizable drop in consumer inflation expectations reflects declining uncertainty about prices, with general agreement across all demographic groups and political persuasions that the inflation outlook has improved.

In the initial reading of the University of Michigan consumer-sentiment survey for December, consumer sentiment shot up to 69.4 (from 61.3 previously), wiping out all the declines from the previous four months. That’s a big deal. Expectations (66.4 vs. 56.8 prior) and current conditions (74.0 vs. 68.3 prior) both improved. There was also consistency in the broadening view that inflation is firmly on the retreat, independent of factors like political identification, geography, income, education, and age.

Our take: Sure, the Fed looks hard at the monthly Consumer Price Index (CPI) data that’s released every month. But what the Fed watches even more intently is how consumers – who alone are responsible for ~70% of all US economic activity – feel about their finances and the state of the economy. Consumer perceptions of the state of prices have broadly improved, in line with the slow but steady fall in inflation, especially for durable goods, cars, and houses. The improvement in sentiment, along with the feel-good vibes from last week’s better-than-expected jobs data, implies that the holiday shopping season may be stronger than anticipated, and that the Fed’s massive 5.25% in rate hikes are, on whole, working.

Your Guide to When the Fed Will Cut

With inflation on the retreat and signals of an economic slowdown mounting, the Fed must answer two separate questions: What kind of downturn is the economy currently experiencing – a soft landing or something more sinister? Second, when should rates be cut? Previous rounds of Fed rate cuts imply that the Fed may decide to cut before it’s certain whether the economy is in a recession.

Prior to 1990, rate cuts typically occurred only after a recession was already upon us. This was due to inflation being too high (CPI averaged 5.6% from 1980 to 1990) on the eve of economic downturns for the Fed to prioritize downside risks to growth over keeping rates high to fight inflation. Since 1990, the Fed has been able to cut rates at the first indication of economic weakness due to low inflation (CPI averaged 3.0% from 1990 to 2000). In that regard, the situation now is closer to what it was before 1990, making it more difficult for the Fed to carry out preemptive rate cuts.

Another concern is when the Fed will decide that the economy is in a recession: that a decline in business and consumer activity has reached alarming proportions and needs the Fed to respond with stimulus to counteract it. History shows that the Fed begins to acknowledge – via ongoing debates and indecisiveness – that the economy may already be in recession around five months after one has begun.

We’ve stated on our recent newsletters that a recession has likely already begun, in October-November, If we’re correct, and if history is a reliable guide, the Fed likely won’t officially acknowledge the possibility of a recession until February at the earliest. However, the Fed may still cut interest rates before they are certain, and we expect they’ll probably start cutting in May.

What to Watch: Fed Is Starting to Think About Rate Cut Timing

While no one expects the Fed to make any interest rate moves at this Wednesday’s meeting, it could still prove to be a pivotal one. Fed Chair Powell may signal that the Fed is preparing to officially discuss – in the abstract – the conditions that would warrant the first rate cut. Such would be in stark contrast to the Fed’s last meeting in November, when Powell stated that rate cuts haven’t been a topic of discussion with the Fed’s rate-setting committee.

Discuss rate cuts? After last week’s seemingly better-than-expected jobs numbers? Yes, for one simple reason: most economic evidence since the Fed’s last meeting is pointing to a notable decline in economic momentum, and the Fed will probably soon see no logic in keeping rates high and risking a recession.

The recent release of November’s Beige Book, a compilation of data from the 12 Fed district banks detailing the economic conditions in their respective regional economies, showed the mood on main street was the most pessimistic since 2020 and likely negatively impacted the Fed’s psyche.

The latest gauge of holiday sales (retail sales, Thursday) will lend further insight into the consumer’s view of their futures, revealing the reasons why companies will likely keep cutting back on excess inventory (inventory, Thursday). Tuesday’s Consumer Price Index (CPI) and the Produce Price Index (PPI) on Wednesday will likely show that inflation pressures continue to moderate and are approaching a level where the Fed would feel comfortable cutting. However, know that traveling the last mile of getting headline inflation down to the Fed’s 2% target (it’s 3.2% now) will take longer than most expect, giving the Fed plenty of justification to stall on rate cuts.

Finally, the Fed will also release an update to its Summary of Economic Projections, and most notably, an update to its dot plot this week. The revised dot plot will likely show the fed funds rate at 5.4% to

end-2023, 4.6% in 2024, and 3.6% in 2025. That means some on the Fed’s rate-setting committee expect 75 basis points of cuts in 2024 and 100 basis points of cuts in 2025. While the markets focus intently on the dot plot, remember that it always turns out to be a horrible predictor of what the Fed actually does. For more on the topic see: The Dot Plot is Hogwash.

While the Fed projects one thing via the dot plot, financial markets project another, and are assuming over 100 basis points in Fed rate cuts by year-end 2024. If the Fed confirms Wednesday that it will maintain rates at their peak well into 2024, rate markets could be in for a shock.

What Smart Borrowers Are Considering Now: Step-up Interest Rate Caps

Interest Rate Caps typically have one strike rate which, if breached, pays the hedger the difference between the strike rate and the higher interest rate.  Think of the strike as the trigger that prompts an insurance policy to pay once a certain interest rate level is breached.  The hedger buys an interest rate cap at a pre-determined strike, term, and notional principal amount to protect against rising interest rates associated with a floating rate loan tied to an index such as SOFR. The cost, or premium, to purchase a cap is based on several inputs:  Hedge amount, strike, risk-free interest rate, time, and volatility (the unknown variable).

Interest rate caps are more expensive in a highly volatile environment. Thus, borrowers who purchased caps when interest rates and volatility levels were at all-time lows are now confronting higher rate cap costs to extend existing caps or purchase a new cap in conjunction with a loan extension or refinance.

There are numerous cap structuring strategies to reduce the cost of a cap. Any hedging structure that reduces a cap’s cost means accepting some higher level of interest rate risk. However, the reduced cost may more than offset the additional exposure to floating interest rates.

Step-Up Cap – what is it?

Think of a “Step-Up”  as a flight of stairs where the steps represent a series of increasing strike levels.  The borrower, or hedger, starts with a lower strike cap on the first step; then, and after a pre-determined period, steps up to a higher strike. They can even take another step with a strike higher than the second step, and so on.

Let’s assume the borrower wants to buy a rate cap, and/or the lender is requiring one, at a 4.50% strike on a notional amount of $20MM for 3 years.  The estimated cost of the cap is $350,000.  What would be the approximate cost of the cap if the strike in the first year was 4.50%, then steps up to 5.00% for the second year, and 5.50% in the third year?  Under this “step-up” strike scenario, the cost would be $270,000; savings of $80,000.

There are multiple reasons a step-up cap makes sense.  Lenders often require an interest rate cap on short-term bridge financing.  These loans often have a high credit spread due to the associated risk with the asset.  The borrower and lender expect the asset to generate more income over time and increase in value.  The borrower, upon maturity of the loan, can choose to refinance at a lower credit spread or sell the asset.

From an credit underwriter’s perspective, the first year is the riskiest, and generally, the strike is determined based upon expectations of the asset performing in years one and two.  The lender would prefer a low strike for the entire term; but is a low strike too much protection?  In our experience, we’ve rarely seen a term sheet that states the rate cap strike can increase after every year.  However, we have been successful many times in negotiating a step-up cap structure on our client’s behalf.

Assume the forward curve is expecting SOFR to not reset above 5.00% over the next three years.  If the market (i.e. forward curve) is wrong – hint: it always is – and there is a shift to higher rates that exceed 5.00% in the second year, what would be the impact on the bottom line?  Yes, in such a scenario Interest expense would increase by around $100k for the year but keep mind the “step-up” cap structure brought an initial savings of $80k.

Generally, higher interest rates mean the economy is performing well and inflation is rising.  Certain assets perform well in an elevated inflationary environment thereby acting as a natural hedge.

Lenders want your business, and they are willing to accommodate hedge structures that make sense for both parties.  However, the lender isn’t going to help a borrower structure a hedge that saves the borrower money, nor do they have the expertise and resources to find creative hedging solutions for their borrowers.  That is why a borrower should seek the advice of an independent derivatives advisor with capital market experience.

To summarize the analysis of a “step-up” strike structure:

Advantages:

  • Lower upfront premium.
  • Structured to mitigate risk that matches the growth and expected future income of the asset.
  • Flexibility that reduces the risk of prepayment penalties associated with a fixed rate loan.

Disadvantages:

  • Higher strikes in the later years may trigger covenants if the asset isn’t performing as expected.
  • Opportunity cost. Hedger might have been better off buying the lower strike cap.

While there is no slam dunk rate cap structure that works for every deal, are situations where a step-up cap structure makes sense.  Are you facing a loan extension along with the high cost of extending a rate cap while also enjoying a high-performing asset? A step-up rate cap structure may be right for you. Give us a call at 415-510-2100 to discuss your situation.

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