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Market Update

Big banks post strong Q2 earnings, yields continue decline

Date:
July 25, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

Treasury yields and U.S. equities rallied last week as investors digested weak economic data and prepared for the upcoming FOMC monetary policy meeting.

Interest rates

  • Despite falling nearly 20 basis points the week prior, the 10-year Treasury yield resumed its decline, falling 16 basis points to 2.77%, the lowest level seen in two months.
    • The front-end of the curve also saw notable declines and the curve’s steepness, as measured by the popular 2s/10s basis, held the flattening moves from the week prior, narrowing just one basis point to -0.22%.
    • The deep inversion of the yield curve has raised eyebrows in recent weeks given the recessionary signal that it flashes, but many analysts have highlighted that the timing of a recession varies widely across historical examples of curve inversion and that the current situation may persist for some time before the onset of an economic downturn.
  • Fed officials entered the blackout period last week in observance of the upcoming FOMC monetary policy meeting later this month.
    • While the Fed speaking calendar was empty, market participants continued to reevaluate their bets for FOMC policy action during the remainder of the year.
      • Looking at Fed Funds futures pricing late Friday afternoon, market participants have fully priced in a 75 basis point hike at the July 26-27 meeting and now expect a 1.75% increase to the Target Range by year-end, 25 basis points lower than the consensus opinion the week prior.
    • Despite the expectation-beating inflation prints earlier this month, medium and long-term inflation expectations have moved modestly lower in the last week and sit below their yearly averages.
      • Real yields remain in positive territory despite falling significantly in the last week.
        • The 10-year real yield fell 14 basis points to 0.43%, while the five-year real yield fell a nearly equivalent amount to end the week at 0.31%, its lowest level since July 5.

        Trading commentary

        • As market volatility remained persistent and elevated, so did hedging activity crossing our balance sheet risk management trading desk last week.
        • Many of the common themes from the last several months continued to play out as we assisted several clients in executing downrate hedges.
          • Specifically, our clients have been primarily utilizing plain-vanilla receive-fixed swaps to pull income forward and mitigate asset sensitivity, while leveraging existing floating-rate assets to receive financial-statement-friendly hedge accounting treatment on those transactions.
          • As noted previously, option strategies have increased in popularity in recent months.
            • To date, zero-cost collar strategies have been deployed far more frequently than strategies that require an upfront premium to enter like floors and floor spreads.
        • Other than simply new originations, we also continue to see a moderate level of activity from clients who have previously executed strategies that protect against an increase in interest rates, unwinding those transactions at significant gains while reducing their asset-sensitive profiles in the current environment.
        • Finally, although uprate hedging strategies have been less popular than their downrate hedging counterparts in recent months, we continue to see clients utilize plain-vanilla pay-fixed swaps and interest rate caps to lock in the cost of current and future wholesale funding, while others look to shorten the duration of longer-term security purchases.

              Big U.S. banks post strong Q2 earnings

              • With second-quarter earnings season upon us, many of the largest U.S. financial institutions have released Q2 earnings in the last two weeks.
              • Broadly speaking, U.S. financial institutions have posted strong performance in Q2 on the back of increased loan growth, higher net interest income, and relatively stable deposit betas.
                • Bank of America, Regions, and KeyBank, among others, boosted their 2022 net interest income guidance last week as the aggressive Fed tightening cycle is expected to continue through year-end.
              • Regions Financial Corp. CFO David Jackson Turner Jr. also highlighted his institution’s use of interest rate swaps to manage downrate risk.
                • Speaking during the earnings call, Turner Jr. indicated that the bank believes “there is a risk that the economy slows to a point where they [the Fed] have to become more accommodative in the latter part of 2023 and 2024,” which is “why you started to see us place some forward starting swaps in those positions.”
              • Roughly two weeks into the earnings season, many financial institutions across the country are yet to report.

                    Economic data

                    • Although last week’s economic calendar was light on data, market participants eagerly awaited the release of several high-profile updates.
                    • The manufacturing industry received another blow as the regional Philadelphia Fed Business Outlook Survey defied calls for a gain and instead fell further into contractionary territory to -12.3, the survey’s lowest level since 2012 excluding the pandemic, on the back of depressed levels of new orders and planned capital expenditures.
                      • In a bright spot, S&P Global’s Manufacturing Index modestly topped the consensus estimate, albeit below last month’s reading.
                    • Housing-related data continued to slump on the back of higher interest rates, with both June’s existing home sales and housing starts falling notably from levels seen in May.
                    • Finally, the Atlanta Fed’s GDPNow tool, which attempts to forecast the current quarter’s GDP in real-time, slipped further to -1.6% for the third quarter.

                          The look forward

                          Upcoming economic data releases

                          • Chicago Fed National Activity Index - Monday
                          • Dallas Fed Manufacturing Activity - Monday
                          • Conference Board Consumer Confidence Index - Tuesday
                          • New Home Sales - Tuesday
                          • FOMC Policy Rate Decision - Wednesday
                          • Wholesale Inventories - Wednesday
                          • Durable Goods Orders - Wednesday
                          • Second-quarter GDP (1st estimate) - Thursday
                          • Core PCE - Thursday
                          • Jobless Claims - Thursday
                          • Personal Spending - Friday
                          • MNI Chicago PMI - Friday
                          • University of Michigan Consumer Sentiment - Friday

                                Upcoming Federal Reserve speakers

                                • FOMC Monetary Policy Meeting - Tuesday / Wednesday
                                • Chair Powell Press Conference - Wednesday

                                  Rates snapshot

                                  Market implied policy path (Overnight indexed swap rates)

                                  Source: Chatham Financial

                                  About the author

                                  • Bill Smith

                                    Associate Director
                                    Balance Sheet Risk Management

                                    Financial Institutions | Kennett Square, PA


                                  Disclaimers

                                  Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.

                                  Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.

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