The Outlook

As inflation and interest rate developments continue to move the markets, we took five minutes to ask Josh Cannington, StoneX Vice President of Interest Rate Derivatives, five questions about what's going on right now - and what to look for in advance of the Fed's next meetings in May and June.

Q1: What's the most important thing that our clients need to understand about this new rate environment?

JC: It's really important for people who are running businesses to understand - or remember - that interest expense is an input cost that should not be ignored. This is true for any business - from agriculture to industrial to even financial services. Most businesses have had the "luxury" since 2007 of running floating-rate credit lines with rates near zero percent.

Now we see that rates can go up - and quickly. So, controlling for those rapidly rising input costs becomes extremely important, because they can lead to significant stress on cash flow and other operational facets of the business.

Q2: What is the biggest misconception you're seeing out there right now?

JC: The biggest misconception I keep seeing is the assumption that rates are going to go back down to near 0% once inflation is tamed - or even if there's a recession. There are two factors working against these assumptions. First, history tells us that rates at current levels are normal. In fact, the 10-year treasury yield is just below the 30-year average. Near-zero rates are the anomaly.  

Second, the Fed has told us that they are looking back to the last time inflation was raging like this for guidance, and that was the 1970s. They say what they've learned is that lowering rates too soon after inflation drops - especially at the first sign of weakening growth - is a mistake, because inflation will jump right back up. That's why they've said explicitly that they intend to hold rates higher for longer this time - north of 5% for the remainder of the year and possibly into 2024. Yet, we've seen the markets either pricing in rate cuts later in the year or simply not pricing in hikes that conditions tell us are coming. I think it's a mistake to underestimate the Fed’s resolve here.

Q3: Is the U.S. economy of 2023 similar enough to the economy of the 1970s that the lessons the Fed is choosing to take from that period still apply?

JC: Today, the U.S. economy is almost entirely services-based, and services inflation is way stickier than goods inflation. Look at labor costs, which are one of the main input costs for services. Right now, we have one of the strongest labor markets on record. An unprecedented imbalance between labor demand and available supply is pushing wages higher. And when wages go up, services inflation goes up or remains flat. If the labor market continues to be this tight, core inflation is going nowhere. 

Q4: What questions are you getting most frequently from clients right now?

JC: I think a lot of our clients are having that age-old feeling: "Did I miss the boat?" They are questioning the disconnect between the Fed's statements and what's being priced into the market. So, those with floating rate debt are asking whether they still need to protect against rising rates - given that only one or two more rate hikes may be coming. Every client situation is different, but the "playbook" we are advocating right now is: stay conservative, hedge for a shorter period of time and hedge a smaller dollar amount.

Right now, fixed rates are opportunistically low - even lower than floating rates, given the rate cuts priced into near-term forwards. But clients are cautious to hedge too far into the future - given that some classic recession indictors are flashing red - with the the deeply inverted yield curve chief among them. Fortunately, a short-dated hedging strategy can provide a borrower with three benefits in today's market: 1) lower interest costs now, 2) protection if the Fed does keep rates higher for longer, and 3) flexibility to reposition into lower rates if we get them.

Q5: What will you be keeping an eye on between now and the Fed meetings coming up in May and June?

Originally published as part of The Outlook Newsletter

Vol. 1, Issue 1C