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Market Update

Curve steepens, Fed talks balance sheet runoff

Date:
April 11, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

After flattening for weeks, the Treasury curve steepened substantially last week with the 10-year Treasury yield rising over 30 basis points as investors digested both hawkish comments from Federal Reserve officials and the week’s busy economic calendar.

Interest rates

  • After inverting the week prior and garnering significant attention from the financial media, the 2s/10s basis widened over 25 basis points last week, erasing the downward move from the week prior and settling near its monthly average.
    • Rates across the curve moved higher week-over-week, but unlike the week prior, the largest moves were seen at the long end of the curve with the 10-year yield ending the week 33 basis points higher at 2.72%, the highest level seen since March 2019.
  • The front end of the curve saw moderate moves higher after hawkish comments from Federal Reserve officials drove investors to price in a quicker tightening pace.
    • Looking at the Fed Funds futures market pricing on Friday, market participants now see an 85% chance of a 50 basis point hike at the May FOMC meeting and are currently expecting over nine quarter-point hikes by the end of 2022.
  • Looking at the year-to-date pickup in yields as we enter the second quarter, the two-year Treasury is up a head-turning 175 basis points on the back of expectations for an aggressive Fed hiking cycle, while the 10-year yield is up a still robust 110 basis points in the new year.
  • Finally, after falling since mid-March, inflation expectations are back on the rise with the major breakeven metrics all rising roughly five basis points on the week.

            Trading commentary

            • Rate volatility has been especially high since the onset of the war in Ukraine, and so too has hedging activity crossing our balance sheet desk.
              • With the strong run-up in rates over March, down-rate hedging activity garnered the lion’s share of hedging activity in recent weeks, but last week we saw a return to more balanced levels of activity.
            • Specifically, we saw several clients convert newly purchased securities from fixed to float while others locked in the cost of next year’s wholesale funding with forward-starting pay-fixed swaps.
            • Looking at the down-rate hedging activity, many clients extended the duration of the floating rate loan portfolio and smoothed future earnings by executing receive-fixed interest rate swaps against floating-rate loan pools.
              • Although swaps hedging the one-month LIBOR portfolio have been the most popular, last week we saw hedges targeting Prime, SOFR, and BSBY loan pools in addition to one month LIBOR pools.
            • Our back-to-back trading desk also experienced a healthy dose of activity last week with borrowers eager to lock in long-term fixed-rate financing in light of the upside risks to inflation.
              • Looking at the hedging activity in the first quarter, one month CME Term SOFR has emerged as the most common LIBOR alternative across our client base, with BSBY and other SOFR indices filling in the majority of the remaining activity.

                      Default probabilities rise across sectors to start 2022

                      • Default probabilities are on the rise across most U.S. business sectors in 2022 according to an analysis by S&P Capital IQ.
                        • Of the 11 sectors measured, only the energy sector saw lower default probabilities since the turn of the year.
                      • A global surge in COVID-19 cases coupled with staffing shortages led the U.S. healthcare sector to experience the largest increase in one-year default probability, rising 1.1% in the first quarter.
                      • In a bright spot, as more workers return to the office and COVID-19 subsides in the near-term, real-estate default probabilities declined quarter-over-quarter modestly.
                        • With Q1 earnings reports just around the corner, anecdotal reports from some of the largest U.S. financial institutions suggest that commercial real estate lending continued to grow in Q1.

                              FOMC meeting minutes

                              • Market participants gained additional insight into the March FOMC meeting following Wednesday’s release of the meeting’s minutes.
                                • According to the release, FOMC participants discussed shrinking the balance sheet by $95 billion per month, much faster than the pace seen in the 2017-2019 campaign, with officials considering a reduction makeup of $60 billion in Treasuries and $35 billion in mortgage-backed securities.
                              • Additionally, “many” officials would have preferred to raise the federal funds target range 50 basis points in March but voted otherwise in light of the uncertainty presented by the war in Ukraine.
                                • Finally, Fed officials look to be prepared to move aggressively in 2022, with the minutes noting a desire to move the policy rate “toward a neutral posture expeditiously.”

                                                      The look forward

                                                      Upcoming economic data releases

                                                      • Consumer Price Index – Tuesday
                                                      • Producer Price Index – Wednesday
                                                      • Retail Sales – Thursday
                                                      • Jobless Claims – Thursday
                                                      • University of Michigan Consumer Sentiment – Thursday
                                                      • Empire Manufacturing Index – Friday
                                                      • Industrial Production – Friday

                                                                                  Upcoming Federal Reserve Speakers

                                                                                  • Bostic, Bowman, Evans – Monday
                                                                                  • Brainard, Barkin – Tuesday
                                                                                  • Mester, Harker – Thursday

                                                                                                                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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