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Market Update

Curve inversion accelerates, CPI tops expectations

Date:
July 18, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

Treasury yields oscillated in a large band last week with the long end of the curve seeing notable declines as market participants reacted to the latest inflation data and recalibrated their expectations for FOMC policy rate moves in the coming year.

Interest rates

  • While volatility remained elevated across all points of the Treasury curve, short-term yields ended the week roughly unchanged, while the long end of the curve declined over 15 basis points on the week.
    • The curve continued to flatten as the 2s/10s basis moved even further into negative territory to end the week at -0.20%, over 15 basis points lower than the level seen the previous Friday and the lowest level seen since December 2000.
  • Looking at Fed Funds futures pricing, market participants continue to expect the FOMC to raise the Target Range an additional 2% from current levels by year-end.
    • Although the week-over-week change in expectations was muted, market participants briefly priced in a 75% chance of a 100 basis points hike at the FOMC’s next policy meeting in late July following a hotter-than-expected Consumer Price Index (CPI) reading on Wednesday.
    • Market participants shaved bets for a 100 basis points hike on Thursday however, after Fed Governor Christopher Waller threw cold water on the idea arguing that, “you don’t want to really overdo the rate hikes,” and signaling that he supports another 75 basis point hike in July.
      • The Fed speaking calendar was packed last week, and all speakers highlighted the FOMC’s focus on combatting inflation and achieving the Fed’s price stability objective with most speakers expressing support for another 75 basis point move in July.
  • Although the latest CPI release topped expectations, the major breakeven inflation metrics held the levels seen the week prior.
    • The Fed-preferred five-year forward, five-year breakeven inflation rate inched down roughly one-half of a basis point to 2.09%, modestly below the yearly average of 2.25%.
  • After seeing a significant run-up the week prior, real yields retreated last week.
    • The five-year real yield declined five basis points to 0.46%, while the 10-year real yield declined 16 basis points to end the week at 0.86%.

      Trading commentary

      • As we get our footing in the third quarter, many of the themes from the second quarter have remained true in the third quarter thus far.
      • Our balance sheet risk management desk continues to see significant hedging activity from our clients on both sides of the table.
        • To date, down-rate hedging activity represents approximately 70% of the trade executions seen this year, while the remaining 30% of trading activity is composed of up-rate hedging strategies.
      • Specifically, the most popular strategy this year has been the income-producing, asset-sensitivity-reducing receive-fixed swap strategy pointed at the floating-rate loan portfolio.
        • While hedging the legacy one-month LIBOR portfolio introduces some complexity in the structuring and accounting of these strategies, the one-month LIBOR portfolio has been the most popular hedge vehicle to facilitate these strategies as many of our clients have significant commercial real estate exposure tied to one-month LIBOR.
          • Alternatively, we have seen clients look to bypass the complexities of the LIBOR transition entirely and instead look to loan balances tied to Prime as many clients have robust HELOC portfolios tied to the Prime index.
        • Although activity has slowed in this space somewhat, we continue to see clients prepare for a downturn in rates by taking off pay-fixed hedges executed in the 2020 - 2021 timeframe, realizing substantial gains on those hedges.

          U.S. financial institutions boost net interest income guidance

          • As the second-quarter earnings season kicks off, we received commentary from executives at some of the largest financial institutions in the U.S. last week.
            • JPMorgan, Wells Fargo, and Citi each raised their 2022 net interest income guidance on the back of expectations for an aggressive Fed rate hike initiative during the final two quarters of the year.
            • Notably, JPMorgan CFO Jeremy Barnum highlighted recent deposit action, indicating that wholesale deposits have seen outflows in search of higher rates while consumer accounts saw little movement.
              • Speaking during the second-quarter earnings call, Barnum seemed pleased with the deposit outflows, saying that it is “actually something that we want, all else equal.”
          • Earnings season is set to ramp up in the coming weeks and a broader picture of the earnings outlook will be painted soon, but to date, much of the commentary from U.S. financial institutions has been positive.

              Economic data

              • While last week’s calendar was packed with high-profile economic data releases, nothing grabbed the attention of market participants quite like Wednesday’s release of the CPI.
                • According to the Labor Department, consumer prices rose 1.3% last month as food, shelter, and energy costs pushed higher in June.
                • Heads turned when the yearly figure clocked in at 9.1%, higher than the consensus estimate and a new four-decade high.
                • Looking at the core measure, which strips out the often-volatile food and energy components, prices rose a still robust 0.7% in June, modestly higher than the core increase seen in May.
              • The manufacturing industry received good news on Friday when the regional Empire Manufacturing Index defied calls for a decline and instead posted a substantial gain to 11.1, the highest reading for the index since April and only the third expansionary reading for the year.
              • Finally, retail sales topped the consensus estimate, increasing 1% in June.
                • Notably, the retail sales figure is not adjusted for inflation and some analysts highlighted that the inflation-adjusted reading was likely flat to modestly down.

                  The look forward

                  Upcoming economic data releases

                  • Housing Starts - Tuesday
                  • Building Permits - Tuesday
                  • Existing Home Sales - Wednesday
                  • Philadelphia Fed Business Outlook Survey - Thursday
                  • Jobless Claims - Thursday
                  • Leading Index - Thursday
                  • S&P Global Manufacturing / Services PMI - Friday

                      Upcoming Federal Reserve speakers

                      • Brainard - Tuesday

                        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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