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Chair Powell reiterates FOMC’s “unconditional” fight against inflation

Date:
June 27, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

After experiencing a modest pickup the week prior, Treasury yields across the curve declined last week, while the major U.S. equity indices all turned green, as investors digested the latest economic data and comments from Federal Reserve officials, most notably, Fed Chair Jerome Powell.

Interest Rates

  • Treasury yields continued the trend that started at the end of the week prior, falling on the back of expectations for a slowing U.S. economy and a slightly more dovish Federal Reserve than expected before the June FOMC monetary policy meeting.
    • The curve’s steepness, as measured by the 2s/10s basis, remained roughly unchanged last week as the 2s/10s basis increased a very modest one basis point to end the week at 0.09%.
    • Much of last week’s decline in the front-end of the curve resulted from a pull-back in expectations for Fed rate hikes at the November and December FOMC meetings as investors are now pricing in an additional 175 basis points by the year’s end compared to 200 basis points the week prior.
  • Notably, market participants continue to expect a 75 basis points hike in July, reinforced by Chair Powell’s comments in front of Congress last week that the FOMC’s fight against inflation is “unconditional” and that restoring price stability is critical “to be able to have a sustained period of maximum employment.”
    • A host of Federal Reserve officials also held speaking engagements last week, each expressing an urgency around curbing the inflationary environment including Federal Reserve Governor Michelle Bowman who expressed a desire to raise the Target Range by another 75 basis points in July.
  • Inflation expectations remained roughly unchanged last week with both the Fed-preferred five-year forward, five-year breakeven inflation rate, and the shorter-term five-year breakeven inflation reading declining modestly from levels seen at the end of the week prior.
  • Finally, real yields also saw moderate declines last week, commensurate with the moves seen in nominal rates, as the five-year real yield ended the week at 0.36%, 18 basis points lower than a week earlier but far higher than the levels seen since the onset of the pandemic.

      Trading commentary

      • Hedging activity has remained elevated throughout June on our balance sheet risk management desk as our clients look to manage the interest rate risk on the balance sheet in the face of a historically quick pick-up in interest rates and a highly uncertain economic outlook.
      • Notably, downrate hedging strategies continue to see the bulk of executions with clients primarily looking to the floating rate loan portfolio as the vehicle to receive hedge accounting and accomplish the economic objectives of pulling income forward in the expected rising rate environment and protecting net interest income from a decline in yields.
        • While plain vanilla swaps remain the most popular, we have seen a notable rise in the execution of option-based strategies, particularly zero-cost collars.
      • Nonetheless, up-rate hedging activity has continued in earnest with several clients locking in the cost of current or future wholesale funding last week.
        • Specifically, we have seen some clients return to the FHLB funding strategies that were very popular before the pandemic and use pay-fixed swaps coupled with short-term FHLB SOFR-based advances to optimize their funding costs and synthetically extend the duration of liabilities.
      • Lastly, our back-to-back hedging desk continues to experience significant hedging activity in the form of both new originations and amendments.
        • Looking at nearly two quarters worth of data, borrowers and banks that have proactively amended existing LIBOR-based derivative contracts have primarily re-indexed from LIBOR to CME Term SOFR.

          Underwater bond portfolios provide headwind for tangible book value growth

          • The investment portfolios of financial institutions across the country saw significant value degradation in the first quarter and that trend looks set to continue as we near the end of the second quarter with short- to mid-term Treasury yields over 100 basis points higher than the end of March.
            • According to S&P Capital IQ, public U.S. banks reported an aggregate $64.14 billion unrealized loss in the AFS investment portfolio in the first quarter, markedly below the $4.90 billion aggregate unrealized gain seen at the end of 2021, as the tangible book value metric declined at many of these institutions in the first quarter.
          • Nonetheless, U.S. financial institutions are well-positioned to face economic headwinds according to the recently released Semiannual Risk Perspective report by the Office of the Comptroller of Currency (OCC).
            • In the report, the OCC highlights elevated operational and compliance risks, but concluded that banks’ “financial condition remains strong and positioned to deal with the economic headwinds arising from geopolitical events, higher interest rates, and increased inflation.”

              Economic data

              • Last week’s economic calendar brought a host of high-profile updates that largely pointed to a slowing U.S. economy and easing price pressures.
              • After two regional manufacturing surveys showed manufacturing activity contracting on the east coast last week, both the Chicago Fed’s National Activity Index and S&P Global’s Manufacturing PMI also suggested that manufacturing activity is beginning to slow.
                • Of note, the Chicago Fed National Activity Index defied calls for an unchanged reading and instead declined significantly from 0.47 in April to 0.01 in May, barely remaining in expansionary territory as production levels slipped over the month.
                • Although S&P Global’s Manufacturing PMI also reported declines in activity nationally, market participants looked favorably on the inflation indicators included in the report that showed a modest easing of price pressures.
              • Consumer sentiment continues to dwindle in the face of persistently high inflation according to the University of Michigan’s latest consumer sentiment index release.
                • Digging into the report, the current outlook measure lost ground again in June as consumers grapple with declining stock prices and fears of a recession in addition to high inflation, while inflation expectations have moderated somewhat compared to the preliminary June reading released earlier this month.
              • Looking ahead, the Atlanta Fed’s GDPNow Tool, which attempts to forecast the current quarter’s GDP growth in real-time, now predicts a 0% growth rate in Q2, a stark contrast from the nearly 2% growth level forecasted at the start of the quarter.

                  The look forward

                  Upcoming economic data releases

                  • Durable Good Orders - Monday
                  • Dallas Fed Manufacturing Activity - Monday
                  • Wholesale Inventories - Tuesday
                  • Conference Board Consumer Confidence Index - Tuesday
                  • Richmond Fed Manufacturing Index - Tuesday
                  • First Quarter GDP (third estimate) - Wednesday
                  • Jobless Claims - Thursday
                  • S&P Global Manufacturing PMI - Friday
                  • Construction Spending - Friday
                  • ISM Manufacturing Index - Friday

                                                                Upcoming Federal Reserve speakers

                                                                • Daly - Tuesday
                                                                • Chair Powell, Mester, Bullard - 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

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                                                                  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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