Sticky inflation puts off rate cuts; Fed/market expectations align… for now

May 31, 2024

The Takeaway is a CoBank publication that provides practical commentary on interest rates, derivatives and capital markets activities. These insights come from the professionals in CoBank’s Treasury, Customer Derivatives and Capital Markets groups, and other leaders across the bank—people who are in the market interacting with customers, investors and other lenders seeking to understand what is driving activity.

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Interest Rates: Fed allays market concerns over potential rate hike; is the 2% inflation goal still realistic?

Blaming an inflation environment that remains disconcertingly sticky, the Fed once again left its benchmark fed funds rate unchanged at 5.25% to 5.50% at its third meeting of 2024 in early May.

However, Fed Chairman Jerome Powell quelled some market fears by essentially eliminating any possibility that the FOMC could make an about-face and instead raise rates in 2024.

“The Fed confirmed what the market was expecting,” said Kiran Kini, CoBank senior vice president and treasurer. “The Fed remains cautious, given that inflation is not coming down as quickly as they thought. Some data points that came out after the meeting gave indications that inflation is easing. But the Fed’s stance remains that they want to wait and get confirmation that inflation data will allow them to gain confidence that it will eventually fall toward their 2% target before they decide if the timing is right to cut rates. 

“But Chairman Powell fairly explicitly ruled out the possibility of a rate hike in the near term,” Kini continued. “The market was concerned that maybe conditions are such that the Fed may have more work to do to tighten policy to bring inflation down. But he went out of his way to rule out the possibility, making the point that financial conditions are restrictive and, if inflation doesn't come down, they'll just hold at current rate levels for longer.”

Still, Kini pointed to lingering market fears that the Fed may not be able to achieve its long-term goal of bringing inflation down to 2%.

“The market’s expectations have mostly converged with the views of the Fed for 2024,” Kini added. “But when you look further out, markets are less sanguine than the Fed that they'll be able to cut rates materially toward their long-term expectation of neutral policy rates. The Fed still thinks they can get rates to 2.5%, which is their long-term estimate of neutral. But it seems the market doesn’t share that view, and recent comments from Fed policy makers would indicate that their long-term expectation of neutral is starting to drift higher.”

Kini also noted that the Fed used the May meeting to confirm changes to its quantitative tightening program, which is intended to withdraw excess liquidity and allow the Fed to shrink its balance sheet.

“The Fed announced that it slowed down the pace of its balance sheet runoff, just like we had anticipated,” Kini concluded. “The Fed is getting down to around $40 billion a month in terms of balance sheet runoff, compared to $77 billion previously.”

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Interest Rate Management: Changes in Fed narrative create an uptick in hedging activity

Rising interest rates and heavy hedging activity at the beginning of the Fed tightening cycle created the recent lull in customer hedging activity. But now that the Fed narrative is changing from potentially aggressive rate cutting to wait-and-see, hedging activity is picking up again.

“A noticeable pivot in the narrative coming from the Fed changed borrower expectations, and we've seen an increase in hedging activity as a result,” said Eric Nickerson, CoBank’s head of Customer Derivatives. “There’s a segment of customers who have shifted their expectations from a near-term aggressive easing cycle to things staying where they are for the foreseeable future and seeing an opportunity to possibly better manage their interest rate expense.” 

Nickerson also noted the upcoming maturity of many hedges entered into at the beginning of COVID-19 in 2020.

“Many of those hedges are maturing in the next year or so, and borrowers are likely going to be faced with a significant increase in their overall borrowing cost,” Nickerson added. “That hasn’t resulted in new hedging activity as of yet, but it has become a noticeable theme as customers become more mindful that their days of enjoying very low rates are coming to an end.”

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Capital Markets: Fed’s loan officer opinion survey cites reasons for commercial bank pullback

The lending fallout among U.S. commercial banks continues and appears to be worsening. 

According to Federal Reserve Economic Data (FRED), the value of commercial and industrial (C&I) loans held by U.S. commercial banks decreased from $2.81 trillion at the end of March 2023 to $2.77 at the end of April 2024, a $41 billion drop. 

Much of the reduction can be attributed to the largest commercial banks. The top 25 U.S. commercial banks held $1.57 trillion in the C&I loans in March 2023, 55.8% of all such loans. This figure declined over the course of the year to $1.53 trillion, a $36 billion drop.

But why?

The answer comes directly from the commercial banks in the Fed’s quarterly Senior Loan Officer Opinion Survey (SLOOS) on Bank Lending Practices, according to Todd Helman, lead relationship manager for Loan Sales and Trading in CoBank’s Capital Markets group.

“It mostly comes down to tightening loan standards,” said Helman. “According to the SLOOS report, there was tightening specifically around maximum size of credit lines, the cost of credit lines, the spreads of loan rates over the cost of funds and the premiums charged on riskier loans.

“As for why, loan officers identified a less favorable or more uncertain economic outlook, a reduced tolerance for risk and worsening of industry specific problems as important factors,” he added.

Helman noted that as commercial banks have retreated, private credit and the syndicated loan market have picked up the slack (also see the Power & Energy story in the Market Focus section).

Market Focus

Agribusiness

Grain exports show strength against strong dollar; farmers’ holdout bet could be paying off 

While the U.S. dollar remains strong and farmers continue to hold last season’s crop, grain market dynamics remain resilient, says Marcus Wilhelm, western region president of CoBank’s Agribusiness Banking Group.

“Considering where the value of the dollar is, export numbers are holding up reasonably well,” said Wilhelm. “Conventional wisdom says we shouldn’t be shipping much, but corn is on pace with prior projections, and soybeans are a little behind, but picking up as some potential concerns with South American production are emerging.

“Amid that, grain sales are still 35% to 50% behind last year’s sales to date,” Wilhelm continued. “The positive is that when some end users have been caught short of supply, they’ve been willing to pay up for it, which means strong margins for our grain customers.”

Wilhelm added that production concerns in some corners of the globe, combined with the potential for a later-planted crop in the U.S., have caused investment funds to exit the record number of short positions they had amassed over the prior six months.

“They went from about 600,000 short contracts down to 200,000 in all the grain and oil seeds,” Wilhelm concluded. “That gives a bullish lift to the market because traders are saying, ‘Maybe we've reached the bottom, or fundamentals have turned to a new direction.’”
 
Wilhelm pointed to the rally in corn and soybean prices in early to mid-May.

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Digital Infrastructure

Telecom providers seek scale and diversity in recent mergers/partnerships

The telecommunications landscape is shifting as some large and middle-market players are seeking to revive sluggish growth through strategic acquisitions and mergers, according to Andy Smith, managing director, Communications division of CoBank.

Smith points to a spate of recent transactions, including the acquisition of Lumos, a fiber-to-the-home platform, by a joint venture of T-Mobile and EQT; Shenandoah Telecommunications Company’s (Shentel) acquisition of Horizon Telecommunications, an Ohio-based commercial fiber provider; and the merger of Uniti Group with Windstream to create what they call an “insurgent fiber provider.”

“Each of these transactions tells us that scale and diversity really mean something and are becoming more important factors in the telecom space,” Smith said. “In the case of T-Mobile, a pivot into broadband away from slow- or no-growth wireless, provides an opportunity to move into underserved broadband markets where growth is very attractive.

“Scale is becoming increasingly important, too,” Smith continued. “Given the inflationary pressures on equipment and labor, which continues to be tight, how close you are to the front line and how big you are means cost advantages. Scale is more important now than it has been in quite some time.” 

Smith added that, as urban areas are built out, the natural movement of these companies will be to continue to expand in rural areas.

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Power & Energy

Institutional investors become aggressive utility lenders, but hurdles still exist

As commercial bank lending to utilities has become more finicky (also see Capital Markets article)—often requiring ancillary business as a loan condition—institutional investors have become increasingly aggressive.

The institutional investor segment is loosening its lending standards and offering favorable terms to attract new customers, according to Bill Fox, managing director, Capital Markets, with CoBank.

“The institutional investor universe, which includes insurance companies, debt funds, collateralized loan or debt obligation instruments—basically non-relationship lenders—has become very aggressive compared to a year ago,” said Fox. “They’re tightening their spreads—or reducing profit margins—loosening terms and becoming much more borrower friendly.

“But the issue is that not everyone has access to this market,” he added. “Institutional investors are bond or private placement buyers, and selling bonds requires you to be an SEC filer—or produce SEC-equivalent securities disclosures—and go through an even higher level of regulatory scrutiny.

“Institutional investors are also focused heavily on due diligence issues, such as fire mitigation plans and capital expense,” Fox concluded. “That’s where CoBank comes in. We can be price competitive, serve as a trusted advisor and we have the industry knowledge to understand issues such as fire mitigation and utility-focused capital expense.”

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