Markets signal aggressive rate cuts, Fed says hold up; volatility persists

January 26, 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: Easing cycle expected to begin, but are the markets getting ahead of themselves…again?

The Fed is widely expected to begin—and itself is signaling—lowering interest rates in 2024. But not unlike earlier in the rate-hiking cycle, the Fed and the markets have different views on what the Fed will do.

Kiran Kini, CoBank senior vice president and treasurer, offered his views on potential interest rate movement and inflation.

“It seems fairly evident that the hiking cycle is over,” Kini stated. “The questions now are when does the Fed start easing, how aggressively and over what period of time. That is going to be the theme of 2024. 

“The markets seem to think the Fed will cut rates fairly aggressively,” he added. “We're not completely sold on that view. The Fed has told us their base-case scenario is that they lower rates three times in 2024, with policy rates 75 basis points lower than where they currently are. The markets, however, are pricing in six or seven 25-basis-point cuts for the year. We think the markets are getting ahead of themselves, but understandably so.”

Kini attributes the markets’ enthusiasm to a continuing belief that a hard landing—a potential recession—remains a possibility, which would force the Fed’s hand for more aggressive cuts. 

“The markets think there is a non-trivial chance that we could still end up in a hard landing and the Fed might be forced to cut rates aggressively,” said Kini. “But the Fed is likely to keep pushing back on that. For now, the Fed seems to think in terms of three to four cuts, given their base case is that the economy moves into a growth slowdown and a soft, rather than a hard, landing.”

With respect to inflation, Kini acknowledged December’s uptick in the Consumer Price index (CPI), indicating a slight increase in inflation. The CPI, however, is not the Fed’s primary measure of inflation. Kini said the Fed’s primary gauge—the Personal Consumption Expenditures (PCE) price index—is expected to tick down, with recent trends tracking close to 2%, which is in line with the Fed's target.

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Interest Rate Management: Will the yield curve stop lying to us?

The interest rate yield curve has defied historic expectations since about the time the Fed began raising its benchmark rate two years ago. Historically, when long-term rates are lower than short-term rates—which defines the prevailing inverted yield curve—the market expects an economic slowdown, possibly a recession. Clearly, that hasn’t happened.

Now that rates are expected to decline at some point this year, the questions become, what will the yield curve do, and can we make good decisions based on previously reliable historic performance? In other words: Will the yield curve stop lying to us?

Eric Nickerson, CoBank’s head of Customer Derivatives, says customers aren’t taking any chances while volatility continues to characterize the current environment. He noted that a five- to 10-basis-point intraday movement in long-term rates is not unusual. 

“The inverted yield curve continues to weigh on customers and their decision-making with regard to interest rate hedging discussions,” Nickerson commented. “They’re trying to build more flexibility into their hedging actions, which is manifesting itself in several ways.

“Some customers have begun tiering their hedging maturities,” he continued. ”Rather than a straight seven-year hedge, they might do a three-year, a five-year and a seven-year hedge to tier their rate maturities over the life of their hedging program or their underlying financing. 

“Other customers are just outright buying caps,” Nickerson concluded. “We're seeing an increase in options where they pay a premium for protection in the event rates go above a certain strike point, which is a sunk cost, but gives them all the benefit of potential rate decreases.”

Nickerson believes rate volatility will continue throughout the year, even as interest rates eventually decrease.

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Capital Markets: 2024 leveraged loan activity begins with a bang. However…

Leading off the first full week of 2024, January 8 saw 17 new syndicated loan launches totaling $30.28 billion on a gross basis, according to Bloomberg. It was the highest volume since 2020. 

Such momentum might normally be a sign of optimism, but the activity was heavily concentrated in refinancings and repricings, according to Todd Helman, lead relationship manager for Loan Sales and Trading in CoBank’s Capital Markets group. 

Bloomberg also indicated that the U.S. leveraged loan market saw only one new offering (Kohler Energy led by Bank of America) on Thursday of that week. And, in fact, total outstandings declined by $137 million, Helman said.

“With such a supply imbalance, secondary loan prices effectively skyrocketed and we're seeing a lot of loans in the secondary market trading significantly above par (i.e. 100 cents on the dollar) at this point,” said Helman. 

“When repricings occur like this, the sell-side banks—or administrative agent banks—are looking cut the Secured Overnight Financing Rate (SOFR) interest rate spreads for their borrowers,” he added. “They’re essentially shifting the benefit from loan investors back to borrowers, which indicates an imbalance in the marketplace—loan demand is significantly exceeding supply.

Helman expects the syndicated loan marketplace to rebalance in 2024 as expectations for interest rate movements are sorted out by the Fed.

Market Focus

Agribusiness

Grain sales dry up, but the clock is ticking

With global grain prices still dropping and many U.S. farmers sitting in a strong financial position, grain sales have essentially dried up, according to Marcus Wilhelm, western region president of CoBank’s Agribusiness Banking Group.

“Prices are down dramatically year over year and continue to plummet,” said Wilhelm. “So, farmers’ prevailing mindset is not to sell at current prices, lock the bin doors and wait it out for a period of time because they don’t need the cash right now. 

“For many commercial grain elevators, this isn't a terrible thing because they're earning storage income from producers just to hold the grain,” Wilhelm continued. “But my fear is that when farmers do sell—if only to clear space for next season's crop—they could flood the market, leaving grain companies stuck with inventory they can't move quickly because the processor doesn't need it yet, and they didn't appropriately structure their bid to cover the high cost of carry themselves.” 

Wilhelm expects sales to increase as the year progresses, which will depend, among other factors, on farm storage capacity and cash flow. He noted that fertilizer contracts for the 2025 planting season will come out in the July/August 2024 timeframe, which will force a critical sell/borrow decision because of the large expenditure.  

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Digital Infrastructure

Opportunities abound for fiber networks serving AI data centers; electrical grid challenges likely to abound, too

Data centers are on fire. Figuratively, of course. The figurative arsonist is artificial intelligence, or AI, which is set to have a transformational impact on society and boost economic activity. 

AI’s impact on the digital infrastructure market is going to be far-reaching, said Jeff Johnston, lead economist, Communications, with CoBank. Johnston points to the explosive growth of NVIDIA Corporation, dominant manufacturer of the graphical processing unit (GPU) chips that run AI applications, as a proxy for infrastructure and, especially, data center growth. 

Sales at NVIDIA, which currently has a market cap that exceeds $1.3 trillion, grew a whopping 200% in the third quarter of 2023.

“When we think about the impact AI will have on the digital infrastructure market, it's profound,” Johnston said. “The size and scope of the new data centers we're going to see over the next few years is going to be enormous.

“And that has implications for companies that build fiber networks,” Johnston added. “These data centers need to be connected with fiber to other data centers and other networks, so there's going to be huge upside demand for fiber infrastructure.

“The scary part is that the electrical grid isn’t ready for this kind of load increase,” Johnston concluded. “The servers running these NVIDIA chips require an enormous amount of electricity, and the grid is not ready.”

Given the explosive growth from AI applications, the impending power grid issues, and the fact that it takes about three years to build a data center, navigating these dynamics to ensure market demands are met will be a major challenge.

Recent CoBank Capital Markets Activity

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Power & Energy

Commercial banks express optimism; CoBank remains a steady capital provider

As is typically the case, the new year brings new optimism. In recent memory, however, optimism among commercial bankers and their ability to provide capital hasn’t lasted much beyond the first quarter. 

A year ago, rising interest rates inhibited borrower demand. The same rising rates put banks’ Treasury portfolios deeper underwater, squeezing their capital positions and making them leery of doing much lending.

But now that two years of Fed tightening appears to have ended, and with potential rate cuts in the offing, 2024 feels different, says Bill Fox, managing director for Capital Markets with CoBank. Commercial bankers, he says, are responding positively to the improving market conditions. At least for now.

“We're hearing positive words from our commercial bank contacts,” Fox said. “There's been a large rally in many of the markets these bankers cover. The stock market generally has performed well, certainly through the fourth quarter. And the Fed has stopped raising interest rates, which has caused loan rates to come down and become more attractive to borrowers. 

“The lower rates have also boosted the capital positions at some banks,” Fox continued. “Many of them owned Treasury securities, which were well underwater when the 10-year was at 5%. Now with the 10-year at 4%, they're less underwater. So, it makes you feel better, and maybe you can lend a little more.”

While things feel better, Fox expressed caution about the potential conflict between the views of commercial bank relationship managers and their internal credit or capital committees. Despite improving conditions, capital remains tight at some institutions. 

Meanwhile, he said, CoBank is insulated from these impediments, and has the capital and lending capacity to prudently help qualified customers.

Recent CoBank Capital Markets Activity

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Tri-County Electric Cooperative, Inc.

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