Fed Funds Should be at 4%

Short and sweet this week for two reasons:

1. Next week brings the FOMC meeting
2. I got a new laptop and learned the hard way that autosave wasn’t on… 

If you have a cap to buy in the next couple of weeks, I will walk through the thought process of buy today vs taking on the inflation print Friday and FOMC meeting next Wednesday. 

This Week

• 10T: 4.24%
  • German Bund: 2.47%
• 2T: 4.51%
• SOFR 5.34%
• Term SOFR 5.33%
• Fed Speeches
  • Fed Chairman Powell - The Fed will not wait until inflation hits 2% to cut rates
  • Fed Daly – Looking for more confidence that inflation is moving back to 2%
  • Fed Barkin – Fed will debate if inflation is still elevated
  • Fed Waller – The Fed is drawing closer to an interest rate cut
  • Fed Kugler – Cautiously optimistic inflation is headed to 2% target
  • Fed Williams – Recent inflation data is positive but Fed needs more 
    
    

Is Fed Funds at the Right Level?

WSJ journalist Greg Ip had a good article indicating the Fed should begin cutting now.  I say “good” mostly because it agrees with me.  But it also has a cool graph comparing the various models the Fed uses to help determine the appropriate level of Fed Funds.

Some observations:

• Four out of five models suggest Fed Funds should be closer to 4% right now
  • This helps explain Powell’s belief that current levels are “sufficiently restrictive”
• Those same four models agreed the peak should have been 8%, not 5%
  • This is heavily influenced by the need for rates to be higher than inflation for the models to believe they are in restrictive territory (aka positive real rates)
    • They do not try to account for where inflation was heading, so the 8% would have been an overshoot as inflation was plunging
• All the models suggested the Fed should have started hiking in ‘21 
  
  

The “first-difference” model is the outlier because it compares today’s data to yesterday’s data and measures the change, aka the difference.  During periods of extreme economic data volatility, like covid, it swung wildly.  During periods of stability, like today, it tends to converge with actual Fed Funds.  This also suggests that if data starts to experience more rapid changes (like unemployment rate surging), it will call for lower Fed Funds very quickly.

The Fed acknowledges these models on its website. They have a historical version that also has some interesting observations:

1. The band of expected Fed Funds is generally within 1% and frequently much tighter
2. The models actually agree more during tightening/easing cycles
3. When there’s a divergence, actual Fed Funds moves toward the models

Going back to the original graph, an argument could be made that the Fed should cut 1.00% even if the economy doesn’t slow at all. If it slows, these will all shift below 4%.

Cap Pricing 

Last week we examined how cap pricing will behave over the next 6-12 months if history repeats itself.  This week we will instead look at how they might behave in three different rate paths.

Higher For-ever: instead of “higher for longer” we call this “higher for-ever”, FF/SOFR stay at current levels 
Soft Landing: rates drift lower to 3.50%
Hard Landing: Fed ends up slashing to 2.50% faster than anticipated 

We will again look at three different tenors (1yr, 2yr, and 3yr).

Remember, cap prices are driven primarily by two different factors:

• Rate expectations
  • Best expressed through the forward curve
• Volatility
  • Wild/mild intraday swings or pressure on big days (FOMC meeting, NFP Friday, etc)
  • Also plays over a much longer time horizon, which we tend to think of this as “certainty vs uncertainty”
    • How confident is the market in the range out outcomes?
      • In 2012, the Fed said they were on hold for three years and vol collapsed
      • Contrast that to the environment over the last two years where the market really had no confidence in its own projections
        • The best description a client ever used for this was buckshot coming out of a shotgun. The further downrange the pellets travel, the wider the range. Traders have to charge for these potential outcomes.

These two can move independent of one another. The classic scenario is on the day of a Fed meeting. Even if Powell delivers a dovish message and rates move lower, this can be entirely offset by high volatility we experience that day.

In the scenarios below, we created a matrix where these two components can move independently.

Lastly, we stuck with one strike: 4.50%. If you have a particular scenario you’d like to see, we have these models all built up and can quickly shoot you back your numbers. Maybe the most important thing to note is that low strike caps (eg 1.50%) will not experience a similar drop as a 4.50% strike.

Let’s start with a 1yr cap.

1 Year Cap

In 5 out of the 9 scenarios, one year cap costs increase between now and year end. The higher for longer scenario basically moves cap prices back to their peaks from last October (not coincidentally when the higher for longer sentiment was peaking). A 113% increase is more than 2x current prices.

In a high volatility environment, cap costs could increase even if the Fed starts cutting. I put a low likelihood on this overall, but one obvious example would be the election.

• If the Fed has started a cutting cycle and you are pricing right around the election, a one year cap could cost more than it does today.

If I had to pick a most likely scenario, I’d go with Soft Landing and Low Vol (-31%) with pockets of Moderate Vol (-10%) and High Vol (+17%).

As we pointed out last week, one year caps stand to benefit the least from rate cuts since the forward curve is projecting so few in the early months.

If your timeline extends into next year, however, your odds improve. As long as the Fed starts cutting at all, prices should come down even in high vol environments. And there’s a really good chance that prices are down substantially.

It seems unlikely that we have a hard landing by year end. But those odds likely increase the further into next year we move. A weighted probability outcome starts shifting these costs towards the right.

2 Year Cap

Higher for-ever really starts punishing the longer term caps, but at least we are down to 4 out of 9 scenarios are more expensive.

Same as before – even in high vol environments, in 6 out of 9 scenarios, this cap costs less than today. And likely much less. A $100k cap today could cost $5k this time next year (with a 4.50% strike and ignoring a bank’s minimum trading cost).

3 Year Cap

Higher for-ever gets really ugly here, but the benefit of lower prices starts picking up steam as we stretch out the timeline to capture a much lower forward curve.

Lots of scenarios with significantly lower costs.

Takeaways

If your timeline is between now and year end, your upside might be limited by volatility

• Especially true for one year caps

This analysis is for new caps, but the concept extends to in place caps as well. Existing caps are likely to lose a lot of value if the Fed doesn’t keep rates up and vol doesn’t remain elevated.

• This is exasperated by the fact that existing caps are bleeding off value each month that passes. A one year cap you buy today will lose half its value by year end even if the market environment doesn’t change at all.

This is a snapshot. A year from now it could make sense to buy a 3 year over kicking off a series of rolling 1 year caps.

Should I Wait for The FOMC Meeting?

This is one of the most common questions we get, and the first two things we ask:

1. What term?
2. What strike?

The shorter the term and the lower the strike, the less you will be impacted by the Fed meeting. In fact, one year caps likely have more downside for waiting because vol always increases around an FOMC meeting, so you would really need a very dovish signal from Powell to offset the increased cost attributable to vol.

Just as importantly, Friday brings Core PCE.

On June 12^th, the Fed’s updated Summary of Economic Projections raised the year end forecast for Core PCE to 2.8%. The consensus forecast for Friday’s Core PCE is 2.5%.

2.5%. They are raising their forecasts while inflation is falling. Who does that? How can you beat a data dependent dead horse but can’t be bothered to double check your forecasts when you get new data? You have one job…

Unless Powell says the Fed is cutting in September, that incongruity suggests the market will focus more on Friday’s Core PCE than the Fed meeting next week.

Let’s say it comes in at 2.5% and rates drop, that would be good for cap prices. But then we need to know where vol is – if it’s still elevated, your cost may not drop. Sometimes vol can settle in the day or so after a major data point, but in this case we immediately start bumping into an FOMC meeting.

You need a combination of falling rates and flat/falling vol to benefit. And option traders don’t know, so don’t bother asking me.

The Week Ahead

The back-end of the week is what everyone has their eyes on as we await fresh GDP and PCE data and I move one step closer to winning my Core PCE Wager with JMo.

No Fed speak as they go dark ahead of the meeting next week.