Big NFP beat sends yields higher

Interest rates

• After falling significantly across the curve in the wake of the FOMC monetary policy meeting on Wednesday, Treasury yields rebounded to end the week higher than where they started as investors priced in the expectation-beating non-farm payroll report on Friday.
  • The 2-year Treasury yield climbed 11 basis points during the week to 4.30%, while the 10-year yield ended the week one basis point higher at 3.53%.
  • The strong run-up at the front-end inverted the curve further, sending the 2s/10s basis closer to the multi-decade lows set in December.
• Although expectations briefly turned lower on Wednesday, market participants are now pricing in an additional 25 basis point hike at the May or June FOMC meetings, in addition to the 25 basis point hike expectation for the FOMC’s next monetary policy meeting on March 22–23.
  • In totality, current expectations call for two more 25 basis point hikes from current levels before a series of 25 basis point cuts take center stage to end 2023 and begin 2024.
  • The expectation for rate cuts at the end of the year marks a stark contrast to what Fed officials, including Fed Chair Jerome Powell, have forecasted for the policy rate at recent speaking engagements and in the official dot plot.
  • At the press conference following the FOMC’s decision to raise the Target Range by 25 basis points on Wednesday, Chair Powell emphasized that there is “more work to do” and that moving inflation back toward the 2% average target “will likely require maintaining a restrictive stance for some time.”
• Finally, the Fed-preferred measure of inflation expectations, the 5-year forward, 5-year breakeven inflation rate, declined notably to 2.16% from 2.31% a week earlier, reflecting the progress the FOMC has made on combatting inflation and inflation expectations in recent weeks.

Trading commentary

• Hedging activity continued at a brisk pace as we entered February.
• As stated previously, hedging activity has balanced in recent weeks as our asset-sensitive clients continue to mitigate their exposure to falling interest rates, while many clients needing wholesale funding have used derivative strategies to optimize their funding costs.
  • Synthetically lengthening the duration of wholesale borrowings with an interest rate swap has become the most popular strategy crossing our balance sheet strategies desk in the last two weeks, as the need for wholesale funding has risen considerably across our client base.
  • Nonetheless, we have seen several clients utilize fixed-rate assets in the hedging relationship as opposed to borrowings and accomplish a similar economic objective but achieve hedge accounting treatment via the new improvement to the fair value hedging framework, the Portfolio Layer Method.

U.S. banks increase loan loss provisions

• Although we have seen many U.S. financial institutions express cautious optimism for the 2023 outlook in recent fourth-quarter earnings calls, some banks are bolstering loan loss provisions in anticipation of a downturn.
  • According to an analysis conducted by S&P Capital IQ, of the 51 U.S. banks with assets ranging from $10 - $50 billion, 41 institutions reported a yearly increase in the fourth quarter, while roughly half reported increases sequentially.
  • The move mirrors the actions of larger U.S. institutions, where approximately two-thirds of the institutions with greater than $50 billion in assets have increased loan loss provisions in the last quarter.

Economic data

• Market participants received updates on several high-profile economic releases last week.
• The manufacturing outlook worsened after several manufacturing-related readings pointed to declining activity.
  • The national ISM Manufacturing Index fell to a five-month low in January after new orders and production levels continued to slide.
  • The January release marked the weakest reading for the Index since May 2020 and highlighted the ongoing struggles in the industry as survey commentary focused on depressed levels of orders but improving supply chains.
  • January’s S&P Global Manufacturing PMI and December’s construction spending figure, released last week, also fared poorly, and pointed to declining activity levels.
• According to the Labor Department, the U.S. economy added 517,000 jobs in January, nearly three times higher than the consensus estimate and the highest monthly increase since July 2022.
  • The significant beat in expectations sent yields notably higher on Friday as market participants forecasted that the Fed would have room to stay higher for longer amid a strong labor market.
  • Lastly, the unemployment rate unexpectedly declined to 3.4% in January, a 53-year low.

The look forward

Upcoming economic data releases

• Trade Balance – Tuesday
• MBA Mortgage Applications – Wednesday
• Wholesale Inventories – Wednesday
• Jobless Claims – Thursday
• University of Michigan Consumer Sentiment – Friday

Upcoming Federal Reserve speakers

• Powell, Barr – Tuesday
• Williams, Cook, Barr, Kashkari, Waller – Wednesday
• Waller, Harker – Friday

Rates snapshot

Market implied policy path (overnight indexed swap rates)