After this week’s CPI data, markets are now pricing in a 96% probability of a rate cut in September and just a 6% probability that Fed Funds is above 5.00% at year end.
Perhaps more importantly, there’s a 50% chance Fed Funds is below 4% at this time next year.
This Week·
- 10T: 4.19%
- German Bund: 2.49%
- 2T: 4.56%
- SOFR 5.34%
- Term SOFR 5.33%
- Fed Speeches
- Fed Chairman Powell – Holding rates high for too long could jeopardize economic growth
- Fed Daly – U.S economic data now justifies an interest rate cut
- Fed Goolsbee – Profoundly encouraging June CPI data makes case for rate cuts
- Fed Cook – US data is consistent with a soft landing
- CPI y/y 3.0% vs. 3.1% expected
Inflation
Well, now what?
CPI came in cooler than expected across all measures and the Fed’s inflation forecasts from just a few weeks ago look pretty out of touch already.
July 26th brings the next Core PCE print. Following last week’s CPI/PPI data, Bloomberg revised its Core PCE forecast to 2.5%. This is the exact scenario I’ve been wondering about for months. At the last FOMC meeting, the Fed was projecting year end Core PCE of 2.8% and we might be at 2.5% by end of Q2.
This happened last year, too. On the day of the last hike, the Fed was projecting Core PCE would finish the year at 3.9%. It finished at 2.9%. Here we are repeating the exact same mistakes as last year. If a dumb state school kid knew the Q1 CPI was noisy, why can’t Fed officials?
There is a growing likelihood the Fed has waited too long to cut rates. If they are unwilling to update their forecasts when new data is released, and if we hit year end forecasts at the mid-way point, how can we trust their judgement on when the first cut should come?
Remember – the braking action required to get CPI from 9% to 3% isn’t the same amount of braking action needed to get from 3% to 2%.
And the longer we wait to adjust the braking action, the greater the risk we come to a screeching halt, leaving skid marks all over the road as we come to a jarring halt.
How Might Caps Behave?
It’s never too early to start considering how to approach cap purchases in a falling rate environment. Term and strike have a big impact on how cap pricing might look over the next 6-12 months as the Fed begins cutting rates. For our purposes, we incorporated movements from the last five cycles. This means you get the classic slash and burn rate cutting cycles as well as the soft landing from 1995.
Strikes
This analysis is tricky because of how different strikes behave in different rate environments and different volatility environments. The starting point is At-The-Money (ATM), which is what the market expects SOFR to average for a given time frame. For those in the know, this is nothing more than what a swap rate is, too.
We use the ATM as the baseline, then look at ATM + 1.00% and ATM – 1.00%.
Term
We look at 1, 2, and 3 year terms. We group the analysis based on term. Please note the right axis changes between terms.
Timeline
We look at how these different structures may behave over the next year, with an orange vertical line to signal year end.
3 Year Cap
ATM – 1.00% = 3.25% (top arrow)
ATM = 4.25% (middle arrow)
ATM + 1.00% = 5.25% (bottom arrow)
The high strike 5.25% benefits the least because the market has already taken off the risk that the Fed will hike again. It falls by 36% by year end.
The two other strikes both fall by 45% by year end.
2 Year Cap
ATM – 1.00% = 3.75% (top arrow)
ATM = 4.75% (middle arrow)
ATM + 1.00% = 5.75% (bottom arrow)
The low strike benefits the most. This is because the delta between the strike and the path of rates narrows as the Fed cuts. This is state school math. As SOFR falls from 5.33% to 5.00% to 4.75%, the cap provides less and less payout.
1 Year Cap
ATM – 1.00% = 4.25% (top arrow)
ATM = 5.25% (middle arrow)
ATM + 1.00% = 6.25% (bottom arrow)
The two higher strikes barely budge. If you’ve got a one year cap extension between now and year end, there’s not a lot of good news on the horizon unless the Fed ends up cutting much faster than expected.
Conversely, if your strike is more like 4.25% you could see the price drop by as much as 70% by year end.
Basic Takeaways
Cap prices are poised to drop in 2H, perhaps substantially.
In general:
- Waiting as long as possible to buy a replacement cap
- Terminating an existing cap as soon as possible if you are refinancing/selling
- Lower strikes will see a bigger drop
- Longer terms will see a bigger drop
Caveats
- Past performance is not an guarantee of future results
- We had a nasty false start in January
- This analysis simply assumes rates and caps behave like they have in previous cycles
Next week we will take a look at how caps might behave based on the pace of cuts. Teaser alert – if the Fed doesn’t cut 3 times over the next year, cap prices could increase.
The Week Ahead
This is the last week for the Fed to tweak messaging ahead of the July 31st meeting since they will go dark next week.
The ECB meets this week. Remember, they started cutting rates at their last meeting. They won’t cut rates this week, but they will likely signal another cut in September.
