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Market Update

Core consumer inflation sets 40-year high

Date:
October 17, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

Treasury yields continued to move higher across the curve as hotter-than-expected inflation data and hawkish comments from Federal Reserve officials prompted market participants to recalibrate their expectations for Fed policy action in the near term.

Interest rates

  • Treasury yields legged higher again last week.
    • The short end of the curve saw the most pronounced movements as the 1-year and 2-year Treasury yields increased 26 and 18 basis points, respectively.
    • The 2-year yield briefly topped 4.50%, the highest level since 2007, before falling slightly to 4.48% by the end of the week.
    • While more muted when compared to movement on the short end, the long end of the curve also saw notable moves upward, with the 10-year Treasury increasing 11 basis points to end the week at the psychologically-significant 4.00% level.
  • Although upward surprises to the week’s inflation data accounted for much of the last week’s move higher, hawkish comments from a slew of Federal Reserve officials drove investors to price in additional rate hikes by the end of Q1.
    • San Francisco Fed President Mary Daly highlighted a desire to move the Fed’s policy rate to between 4.5% to 5.0% after a “very disappointing” inflation report.
      • Notably, Daly indicated that once the Fed levies its final rate hike, expected in 2023, she believes that the Fed will “hold at that point for some time,” a fact pattern inconsistent with current market pricing that forecasts interest rate cuts beginning in late 2023.
    • While most officials reiterated the Federal Reserve’s commitment to raising interest rates, Minneapolis Fed President Neel Kashkari turned heads when he gave a dovish nod to market participants emphasizing that the Fed “could always stop what we’re doing” if economic conditions deteriorated significantly.
  • Finally, last week’s hot Consumer Price Index release materially shifted market participants’ expectations for Fed rate hikes in the next six months.
    • A 75 basis point hike is now fully priced in for the early November FOMC meeting, with a 15% chance of a 100 basis point hike currently reflected in market pricing.
    • More notably, expectations for hikes through the end of Q1 shifted materially as market participants now see an additional 50 basis points of rate hikes by the end of Q1 2023 compared to one week ago.

Trading commentary

  • Hedging activity remained elevated last week as clients looked to fine-tune their interest rate risk positions in the face of significant global economic uncertainty and four-decade-high inflation in the U.S.
  • As previously reported, we continue to see most of the hedging activity coalesce around strategies that prepare for a downturn in interest rates.
    • Plain vanilla interest rate swaps remain the most oft-used derivative instrument to hedge interest rate risk, but we continue to see a steady pace of option-based executions, most notably with zero-cost collars and floor spreads.
    • Although the 1-month LIBOR and Term SOFR commercial real estate portfolios are often used as support for the hedging relationship in these downrate hedging strategies, we have seen some clients look to the floating rate securities portfolio, most often CLOs, and the fixed-rate debt portfolio in recent weeks to achieve hedge accounting.
  • Finally, the need for wholesale funding appears to be increasing in aggregate across our client base.
    • Plain vanilla pay-fixed swaps designed to optimize wholesale funding costs, most often from the FHLB, have been increasingly used in recent weeks as our clients report the beginnings of deposit runoff.

Big banks report Q3 earnings

  • Several large U.S. financial institutions reported third-quarter earnings last week.
    • JPMorgan Chase increased its net interest income guidance for the full year 2022 on the back of expectations for more Federal Reserve rate hikes than previously thought but cautioned that the bank and the U.S. economy are likely to face “fairly significant headwinds in the near future.”
    • Notably, JPMorgan Chase Chairman and CEO Jamie Dimon appeared optimistic for next year’s outlook, commenting that the consumer is “very strong” and suggesting that even if the U.S. economy were to enter a recessionary period, it would do so “with a healthy consumer and very healthy business.”
  • Third quarter earnings season has just started, and many U.S. financial institutions will be reporting third-quarter earnings in the coming weeks.

Economic data

  • Although high-profile updates packed last week’s economic calendar, the inflation data released mid-week garnered much of the attention.
  • Both the Producer Price Index (PPI) and the Consumer Price Index (CPI) topped expectations last week as inflation remains persistently elevated and sits at the highest level since the early 1980s.
    • Notably, consumer prices accelerated 0.4% in September, double the consensus estimate, while the core CPI measure, which excludes the often-volatile food and energy components, climbed to 6.6% year-over-year, a four-decade high.
    • Digging into the headline CPI report, inflationary pressures remain broad-based, with substantial increases in food, shelter, and medical services driving the expectation-beating figure in the September release.
    • Treasury yields, particularly at the front end of the curve, moved substantially higher in the wake of Thursday’s CPI release as market participants forecasted that the Federal Reserve would continue to tighten aggressively through the end of the year.
  • The consumer appears to be feeling the effects of inflation.
    • September retail sales, which are unadjusted for inflation, were unchanged from a month ago, defying expectations for a 0.2% increase and falling below the 0.4% monthly increase reported in August.
    • Seven of the 13 measured retail categories reported a monthly drop, a stark contrast to the three categories that saw monthly declines in August.
  • Finally, consumer sentiment has stabilized after falling significantly since the start of the year.
    • The preliminary October University of Michigan Consumer Sentiment Index topped both the consensus expectation and September’s reading.
    • While the report showed significant improvement in the “current conditions” measure, consumers’ expectations for the next year’s inflation rate accelerated from 4.7% to 5.1%, the highest reading since July.

The look forward

  • Upcoming economic data releases
    • Empire Manufacturing Index – Monday
    • Industrial Production – Tuesday
    • Building Permits – Wednesday
    • Housing Starts – Wednesday
    • Beige Book – Wednesday
    • Philadelphia Fed Business Outlook Survey – Thursday
    • Jobless Claims – Thursday
    • Existing Home Sales – Thursday
    • Leading Index - Thursday
  • Upcoming Federal Reserve Speakers
    • Bostic, Kashkari – Tuesday
    • Kashkari, Evans, Bullard – Wednesday
    • Harker, Jefferson, Cook, Bowman – Thursday
    • Williams - Friday

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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