| Interest Rate Market Snapshot | ||||||
| Federal Funds | SOFR | 2Y Treasury | 5Y Treasury | 7Y Treasury | 10Y Treasury | |
| 5.33% | 5.33% | 5.04% | 4.71% | 4.74% | 4.72% | |
- The FOMC voted unanimously to leave the Federal Funds target range unchanged yesterday, at the current lower and upper bound of 5.25%-5.50%
- This keeps SOFR and the effective Federal Funds rate at ~5.30%
- The official statement was left broadly unchanged as well, repeating phrases like “the extent of additional policy firming that may be appropriate” to keep the sentiment leaning hawkish
- But the rate hold, and the unchanged statement were a moot point for the markets as it was fully priced in for weeks now
- The updated economic projections, however, did cause a stir and markets reacted
- There, it was the Dot Plot that made the most noise
- 12 of the 19 officials still expect one more rate hike this year, while the remaining 7 are comfortable with rates where they are today
- With just a November and December meeting left, the incoming data over the coming weeks will be vitally important to that decision
- Next year, the Fed is now expecting rates to only drop to 5.10%, roughly 2 less cuts than forecasted in June
- More of that in 2025 too, with the Fed expecting rates to be at 3.90% by year-end vs. 3.40% in June
- Why? The Fed sees resilient economic growth and employment requiring the need to keep rates “higher for longer” – same message that has been said for months now, but markets love graphs and now they have it
- The takeaway seems to be that the Fed is just about done hiking rates. Despite another one penciled in for this year, focus is turning toward cuts – the timing of those cuts and the extent, with the revision of the Dot Plot being used to manage those expectations. However, given the uncertainties of student loan payments resuming next month, a looming government shutdown right around the corner, an auto workers’ union on strike, China navigating a real estate crisis and Europe flirting with stagflation, it does not surprise me that Powell used the phrase “proceed carefully” 13 times throughout the press conference
Powell at the podium
- “Given how far we’ve come, we are in a position to proceed carefully”
- “We’re fairly close, we think, to where we’ll need to get”
- “Stronger economic activity means the Fed needs to do more on rates”… but “I wouldn’t want to handicap the likelihood of a soft landing”
- “There’s so much uncertainty around the timing of rate cuts. The 2024 projections are just estimates made at the moment, nothing more than that”
- Fed Funds:
- 2023: 5.60% (1 more hike possible)
- 2024: 5.10% (2 less cuts than before)
- 2025: 3.90% (2 less cuts than before)
- GDP better than before – well north of recessionary levels
- Unemployment better than before – soft landing positive
- Inflation generally unchanged, puzzling many. The Fed has alluded to needing below trend growth to achieve 2% inflation, and the optimistic changes to both growth and employment are just the opposite of that
- Like every FOMC meeting, there are nuances to digest, and this meeting had plenty
- For example, the 2024 rate forecast is very wide. 13 of the 19 officials expect to cut rates next year (debating how much), 4 see rates unchanged, and only 2 see more hikes needed
- In 2025, the range of outcomes is even greater. The highest rate projection is at 5.60% and the lowest is 2.63% - it’s a guessing game that far out
- And those nuances may be behind today’s pullback on the front end of the curve
- Yesterday, 2-year rates led the move higher. Trading 13 basis point higher from the intraday lows vs. 8-9 basis points for longer dated tenors
- Today, 2-year rates are lower by 4-5 basis points while 10+ year Treasury yields are 10-12 basis point higher – extending the initial reaction from the Fed
- The moves are steepening the curve quite a bit with the 2y/10y now retesting 4 month highs and the 3m/10y spread now less than 100 basis points apart
End-users be patient
- For borrowers looking for an opportunistic entry point for hedging – be patient here
- The difference between SOFR futures and Fed projections (despite how accurate these are for real forecasts) are now very narrow
- And given bid/ask spreads in the 20-basis point range, the “savings” priced into 2–3 year swaps is negligible to what the Fed is forecasting
- If anything, look to caps. Volatility premiums are easing and near the lowest point of the year (the MOVE Index is even testing 2022 lows)
- The Personal Consumption Expenditures index, the Fed’s official and preferred inflation measure, came in lower than expected in August
- Headline PCE rose 0.4% last month (0.5% expected) and Core PCE increased just 0.1% (0.2% excepted)
- The slower than expected rise takes the annual change for both to 3.5% and 3.9% respectively
- Despite playing second fiddle to CPI, today’s report is yet another encouraging development for the Fed’s inflation fight – the monthly core reading was the lowest in over 2 years, and the annual figure finally reached a 3 handle
- And after relentless selling on the long end of the curve, the past two days have seen shorts begin to cover with today’s PCE report adding fuel to the rally
- Since last Monday, 2-Year rates are just about unchanged. From opening at 5.04% on 9/18 to 5.05% today. Given the anchoring effect the Fed has on the front end of the curve, the sideways trading makes some sense. After the Fed meeting, there has been little evidence to suggest the market needs to reprice the risk of the Fed following through with an “insurance hike” in November. Current odds of a hike by year end: still only 35%
- However, the long end of the curve is grappling with several cross currents that ultimately pushed rates higher over the same period. From the 9/18 open to the peak reached yesterday, the 10-year traded 35 basis points higher, yet has already covered 16 basis points over the past two days
- It’s been a notable steepening of the yield curve and helps the transmission of monetary policy
- The economic calendar has been light these past few weeks, and what has been released has come with little, if any, surprises
- With that calm, comes the opportunity for the rates market to refocus on the fundamentals: credit quality, new issue supply and long-term demand
- Caveated by rising oil prices, auto union strikes, and hawkish Fed comments sprinkled throughout of course
Credit Quality
- Last month, Fitch downgraded the United States’ Long-Term Foreign-Currency Issuer Default Rating to 'AA+' from 'AAA', and the change has largely impacted longer dated tenors
- Since the August 1 announcement, 10 and 30-year Treasury bonds have traded 60-65 basis points higher. In fact, the Long Bond is now approaching a key resistance level not seen since 2011: 4.80%, a level tested 4 separate times post GFC
- With the government shutdown looming this Sunday, the threat of yet another downgrade is a clear and present danger
- Moody’s recently commented that a shutdown would be “credit negative” for the sovereign rating. With a longer winded response sounding like: “While government debt service payments would not be impacted and a short-lived shutdown would be unlikely to disrupt the economy, it would underscore the weakness of US institutional and governance strength relative to other AAA-rated sovereigns…it would demonstrate the significant constraints that intensifying political polarization put on fiscal policymaking at a time of declining fiscal strength, driven by widening fiscal deficits and deteriorating debt affordability”
- Simply put, the risk of holding Treasuries is rising and that requires a higher yield to attract buyers. – at least for now
Supply
- Ratings set aside; the US government has serious funding needs over the coming years
- Total US Government Debt: now over $33 Trillion, 130% of GDP, and thanks to rising interest rates will see the interest payments triple from nearly $475 billion to $1.4 trillion by 2032
- And according to the CRFB, by 2053, interest payments are projected to hit $5.4 trillion – more than the US spends on Social Security, Medicare Medicaid, and all other mandatory and discretionary spending programs
- Higher supply, without an equal increase in demand, pressures prices lower (yields higher) – Econ 101
Demand
- Historically, the largest buyers of US debt have been the Fed, foreigners, and primary dealers
- And to absorb the expected flood of new supply, these buyers will need to step up, yet many are doing just the opposite
- Through the process of Quantitative Tightening, the Fed has been rolling off their holdings of US Treasuries and agency debt to the tune of roughly $1 trillion a year, the fastest pace ever attempted
- Central banks from just about every developed economy are in a rising rate environment. The EU and Japan for example, are both walking back historically accommodative policies, albeit at vastly difference paces – sending their government yields higher. China is an outlier in policy, but they too are buying fewer and fewer Treasuries. And with rising yields at home, the incentive to chase returns in the US is deteriorating and foreigner demand for US debt is abating with it
- However, Primary dealers are still buyers, especially money market funds
- When excess cash in the system needs to find a short-term place to be parked, it is done with the Fed’s reverse repo window. There, the market still has almost $1.5 trillion in dry powder to use in absorbing new issues from the Treasury
- So, two of the largest buyers of US debt are stepping back – leaving a huge gap between higher anticipated supply and waning demand – once again, a catalyst to pressure prices lower (yields higher)
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