Zeroing in on the Fed’s Inflection Point

What You Missed

Updates on the state of the jobs market and the service industries breathed new life into hopes of a September Fed interest rate cut. The unemployment rate surprised to the upside as more people struggled to find jobs last month. Layer on news of a surprising softening in the services side of the economy, and one could be justified in thinking that the Fed will cut in September. Unfortunately, the Fed will need at least a few months of corroborating data before becoming confident that a rate cut is justified; we’re sticking to our guns – the Fed won’t cut until December at the soonest.

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Running the Numbers: Rates Fall on Reinvigorated Rate Cut Hopes

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Treasury yields backed off their recent highs over the course of last week, driven lower by news of a softening in the services sector and signals of a weaker jobs market. Both of these factors raised the odds of a September Fed rate cut. As of this writing, futures markets imply a 75% chance of a 0.25% rate cut in September, followed by a 78% chance of another 0.25% cut in December.

Despite the decline, and since the middle of June, the 10-year has struggled to break below 4.2%. It’s stuck mostly because Fed officials continue to say they need to gain more confidence in slowing inflation and jobs outlook before seriously considering cutting interest rates.

The dynamic has created a floor under longer-term interest rates, like the 10 and 30-year Treasury yields, limiting how far they can fall. It’s also clear that the Fed Funds rate, which currently sits at 5.50%, hasn’t proven as restrictive on economic activity as the Fed had hoped. It’s an argument we’ve been making for months now and is evidenced by the Fed’s own gauge that financial conditions are nowhere near restrictive but instead are just the opposite; quite loose. We explored this concept in detail during our Q3 Interest Rate Forecast webinar last week. Did you miss it? Download the slide deck and watch the replay HERE.

For the week:

Where will SOFR be a year from now? 3-month SOFR, a valuable gauge for the true cost of interest rate hedging, fell two basis points to 5.30%. The implied yield on the 3-month SOFR futures contract 1-year forward (June ‘25), an estimate of where markets expect 3-month Term SOFR – and by extension, hedging costs – to be a year from now, fell twenty-one basis points week-over-week to 4.17%, reflecting lower Treasury yields and the financial market’s reinvigorated hopes of a September Fed interest rate cut.

When will SOFR Fall? 1-month SOFR, via the SOFR forward curve, implies that one-month SOFR has peaked near 5.33% and will decline precipitously over the next year as the Fed eventually cuts interest rates in early 2025. The forward curve projects that 1-month Term SOFR will steadily decline from here, eventually bottoming out near 3.59% in November 2027, up one basis point from this time last week.

Where is the 10-year Treasury yield headed? The 10-year Treasury forward yield curve implies the yield will bottom out at 4.19% in February 2025 and then stage a slow and steady sequential rise. With all the US Treasury’s debt issuance on tap in the coming quarters and a seemingly resolute Fed, it’s tough to imagine a 10-year Treasury yield sustainably below 4.20%.

While the forward curves for SOFR and Treasury yields aren’t great forecasts—they’ve proven to be horrible predictors historically—they give one a peak at the market’s current thinking. Given the narrow trading range expectations for the 10-year Treasury, expect the front end of the curve to drop, bringing us back to a more normal sloping yield curve.

When will rate cap costs decline? Rate volatility, a vital driver of the cost of option-based interest rate hedges like rate caps, fell to a one-week low. Rate cap costs continue to hover 25-30% below their peaks and will likely continue their slow, downward path as the road toward the Fed’s first rate cut gets shorter.

Are you curious about what a rate cap costs? Check out our rate cap calculator. The calculator is a valuable tool for providing an estimate, but if the expected start date is a couple of months away or the cap’s notional amount is amortizing/accreting, give us a call at 415-510-2100 for indicative pricing based upon the specific economics.  Cap costs can vary widely – as much as 40% – when considering changes in the notional schedule or “step-up” strike structures.

Elsewhere, equities traded into record territory as dovish comments from Federal Chair Powell and signs that France’s National Rally party won’t achieve an absolute parliamentary majority buoyed markets. A barrel of West Texas Intermediate crude oil edged up  $1.25 to $83.20 as the US Dollar weakened in concert with falling Treasury yields, and Gold strengthened.

Weakening Jobs Market Reignites False Narrative of a Near-Term Rate Cut

Last Friday’s release of the June jobs report – historically the single most impactful piece of economic data for interest rates – showed a mixed bag of data; while many new jobs were created in the month, the unemployment rate rose more than anyone expected. That led many in financial markets to bet on a September rate cut.

Let’s run the numbers –

The headline payroll print showed 206k new jobs were added in June, above the consensus expectation of 190k. May’s headline figure was revised to 218k, down from the 272k initially reported.

Hiring was particularly strong in sectors not heavily influenced by economic cycles, such as government, health care, and social assistance. Additionally, the construction industry experienced job growth. Certain industries, such as retail and professional and business services, experienced a decline in employment. Employment in other sectors remained relatively stable.

The U-3 unemployment rate increased to 4.05% (versus May’s 3.96%), surpassing the consensus forecast of it remaining steady at 4.0%. For perspective, the increase in the unemployment rate brings the three-month moving average to 4.0%—approximately 0.43 percentage points higher than the lowest three-month average recorded in the past year.

Critical for continued consumer spending, hourly and weekly wage growth slowed to 0.3% in June from 0.4% in May.

Our take: The monthly jobs report offers critical insight into one of the Fed’s dual mandates: robust employment. The other mandate – price stability, aka inflation – has improved substantially over the last two years, but those declines in inflation pressures have been small and nearly flat over the last year, proving that the Fed’s inflation fight has stalled. For the Fed to be anywhere near cutting interest rates, they’d have to see renewed momentum in inflation’s decline and/or a substantial weakening in the jobs market. Neither is evident, or even on the horizon, at present.

While most of the new jobs created in June were in economically insensitive sectors such as healthcare and government, the jobs report indicated slower job growth – and even layoffs – in industries heavily relying on discretionary spending. Add evidence from recent jobless claims data that unemployed workers are experiencing extended periods of job search, and it’s easy to see how the unemployment rate has risen.

Bottom line? The June jobs report indicates that tighter monetary policy, via higher interest rates, is making real progress in slowing the economy. However, given that the Fed’s inflation fight has stalled, that progress isn’t fast enough to nudge the Fed toward a September rate cut. The Fed requires more time to view the weakening jobs market as a true trend, and that view will become a trend only if upcoming jobs and inflation data show moves in the right direction in the coming months, and that won’t happen until we’re well into the fall.

Fed Chair Powell said as much in public last week: “Because the US economy is strong and the labor market is strong, we have the ability to take our time and get this right,” Powell said during a panel Tuesday at the European Central Bank Forum on Central Banking in Sintra, Portugal. “And that’s what we’re planning to do.” Translation: According to the most recent economic data, it appears that inflation is starting to decline again. However, the Fed is cautious and requires months of additional evidence before seriously considering a rate cut. September is just too soon.

Service Sector Gauge Shows a Sputtering in America’s Growth Engine

The headline ISM Services Purchasing Managers Index, a measure of business activity, employment, production, new orders, prices, and inventories in the services sector, dropped to 48.8 in June (versus May’s 53.8). Any reading below 50 is seen as a contraction and, hence, a slowing in demand for services. This is especially important given that US consumers, who alone drive over 70% of US economic activity, have directed most of their spending in recent quarters to services over physical goods, and it’s these purchases of services that has driven America’s economic resilience this year.

Our take: It is unusual for the ISM Services gauge to fall into contractionary territory, marking only the second time this year and the seventh time in its 28-year history. It tells us yet again that the Fed’s 525 basis points in rate hikes are slowly working at slowing the economy. The billion-dollar question now: Will spending on services continue to slow, and if it does, will it be fast and abrupt enough to prompt the Fed to cut rates at all this year?

What to Watch: Latest Read on Inflation to Spur Rate Cut Bets Anew

Are you tired of wondering when the Fed will cut rates? Try writing about it every week. Unfortunately for you and us, it’s the dominant theme driving financial markets these days and will continue to be until the first rate cut happens.

It’s becoming increasingly clear that the Fed’s 525 basis points in rate hikes since 2022 are impacting the economy. Most recently, Headline job gains for June aligned with robust expectations, but the unemployment rate saw a noticeable jump.

The week ahead will offer more clues as to whether inflation pressures are softening anew or whether the Fed remains stuck in its inflation-fighting progress. Second-tier job data should reinforce signs that the jobs market is gradually weakening. Neither will be impactful enough to change our outlook on the timing and degree of rate cuts.

Small business hiring plans (Tuesday) have shown a downward trend, and we anticipate them to continue below levels seen before the pandemic. Continuing jobless claims (Thursday) are expected to reveal the ongoing challenges unemployed workers face in their search for new employment. Given the recent indications of a slowdown in economic growth, Fed Chair Jerome Powell is expected to adopt a cautious approach during his semiannual congressional testimony on Tuesday and Wednesday.

However, Thursday’s release of the June Consumer Price Index (CPI) will steal the show this week. The CPI proved softer in April and May, and we expect the trend to continue in June. If we’re correct, it will be more evidence that the stars for the first Fed rate cut are slowly aligning.

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Got a Call – Swap Gambling

Rex Evans got a call from a client asking if  it’s ever a good idea to use swaps to bet on the direction of interest rates.
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