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Market Update

Fed officials reiterate hawkish policy stance, September NFP impresses

Date:
October 11, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

In a volatile week to start the fourth quarter, Treasury yields and the major U.S. equity indices moved moderately higher as market participants digested the latest economic data releases and commentary from a slew of Federal Reserve officials.

Interest rates

  • Despite steepening the week prior, the Treasury curve’s shape remained roughly unchanged week-over-week as the 2s/10s basis, a popular measure of the Treasury curve’s steepness, declined one basis point to -0.43%.
    • The current level of the 2s/10s basis sits just nine basis points above the two-decade low seen at the end of September and remains well below the yearly average of 0.31%.
  • Looking at Fed Funds futures pricing at the close on Friday, market participants’ expectations for Fed policy action during the rest of this year are unchanged from a week earlier.
    • Currently, market participants expect the Fed to raise the Target Range another 1.25% to 4.25% - 4.50% by year-end, matching the median Fed estimate in the September Summary of Economic Projections.
    • While market pricing aligns with the Fed’s median estimate for the policy rate through year-end, there is a notable divergence between the Fed’s and the market’s expectation for policy rate changes in 2023 and beyond.
      • Specifically, the market anticipates the Fed will have to cut rates once in 2023, while Fed projections and commentary both suggest that interest rate cuts would not materialize until at least 2024.
      • Atlanta Fed President Raphael Bostic reinforced the Fed’s hawkish stance on Wednesday and pushed back on the notion of policy rate cuts in 2023 saying, “You no doubt are aware of considerable speculation already that the Fed could begin lowering rates in 2023 if economic activity slows and the rate of inflation starts to fall. I would say: not so fast.”
  • Inflation expectations moved moderately higher last week.
    • The 5-year breakeven inflation rate increased 25 basis points to 2.42%, approximately 50 basis points below the yearly average, as OPEC+ oil production cuts and a strong employment report reignited inflation fears.
    • Real yields moved lower in concert with the increase in inflation expectations with the 5-year real yield falling 14 basis points during the week to 1.78%.
    • Notably, the Fed-preferred 5-year forward, 5-year breakeven inflation rate held constant week-over-week at 2.12%.

Trading commentary

  • While hedging activity has been elevated for much of the second and third quarters, last week we saw an exceptionally elevated level of hedging activity to start the fourth quarter.
  • Last week’s hedging activity mostly centered around strategies designed to protect against a fall in interest rates.
    • As noted previously, we have seen a significant rise in the utilization of option-based strategies, particularly zero-cost collars, and floor spreads, and have also seen a pickup in strategies that directly hedge the 1mo. CME Term SOFR loan portfolio as clients begin to build a critical mass in these portfolios.
    • Although the majority of downrate hedging strategies executed year-to-date have pointed the derivative to the floating rate loan portfolio to achieve favorable hedge accounting treatment, last we saw clients also look to both the floating rate investment portfolio and the fixed rate debt portfolio to achieve hedge accounting treatment.
  • While the lion’s share of hedging activity has been in strategies that prepare for a downturn in interest rates, last week we also assisted clients to protect against further increases in interest rates by implementing the new portfolio layer method strategy to hedge recent 30-year mortgage originations.

U.S. banks slow branch closures in 2022

  • After seeing a record-breaking pace of branch closures in 2020 and 2021 in the wake of the COVID-19 pandemic, bank closures in 2022 have slowed considerably from levels seen since the pandemic.
  • Although branch closures continued to exceed branch openings in the most recent two quarters, the second quarter’s 574 branch closures nationally marked the lowest quarterly figure reported since the first quarter of 2020.
  • Looking at data through the third quarter, 2022 is on pace for a markedly slower pace of closures compared to 2021.
    • According to S&P Capital IQ, the U.S. banking space is seeing 838 branch closures per quarter in 2022 compared to a pace of 1,014 branch closures per quarter in 2021.

Economic data

  • Market participants received a deluge of high-profile economic updates last week, including the September non-farm payroll report.
  • After receiving mixed signals from the regional manufacturing surveys in recent weeks, the September national ISM Manufacturing Index release soured the manufacturing industry outlook.
    • The September ISM Manufacturing release fell notably below both the consensus estimate and the August reading to a two-year low as measures of new orders and employment declined significantly.
    • In a bright spot, the prices paid component declined for the sixth consecutive month and sits at its lowest level since June 2020.
  • Despite the plethora of economic updates, market participants had their attention fixed on Friday’s release of the September non-farm payroll report.
    • According to the Labor Department, the U.S. economy added 263,000 jobs in September, moderately above the consensus estimate but below the 315,000 job additions seen in August.
    • The strong employment report sent interest rates higher across the curve on Friday as market participants viewed a strong labor report as cause for the Fed to continue its current pace of tightening.
    • Notably, the unemployment rate declined more than expected to 3.5%, although analysts noted the drop can be partially attributed to a decline in the labor force participation rate.

The look forward

  • Upcoming economic data releases
    • Producer Price Index – Wednesday
    • FOMC Meeting Minutes – Wednesday
    • Consumer Price Index – Thursday
    • Jobless Claims – Thursday
    • Retail Sales – Friday
    • University of Michigan Consumer Sentiment – Friday
  • Upcoming Federal Reserve Speakers
    • Evans, Brainard – Monday
    • Mester – Tuesday
    • Kashkari, Barr, Bowman – Wednesday
    • George, Cook – Friday
    • Bullard - Saturday

Rates snapshot

Rates snapshot 10 11 22

Market implied policy path (overnight indexed swap rates)

Market Implied Policy Path 10 11 22

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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