Fed-preferred inflation measure tops expectations

Core PCE, Fed minutes send rates to recent highs

• The Treasury sell-off continued in earnest last week after the FOMC’s February meeting minutes, and the latest core PCE reading suggested that the Fed would hold the key policy rate “higher for longer” to bring decades-high inflation back to levels consistent with their stated average 2% target.

Asset-sensitive hedging strategies return

• After experiencing a wave of rising rate hedges to start the year, strategies to protect against falling rates gained steam in the last two weeks as rates have increased across the curve and the cost to hedge for falling rates decreased.

Rising funding costs set to continue amid deposit outflows

• As evidenced in the many Q1 earnings calls in recent weeks and by the hedging activity we have seen crossing our balance sheet strategies desk, competition for deposits is heating up, and wholesale funding needs are increasing significantly across the banking space.

Fourth-quarter GDP, consumer sentiment releases suggest economic strength

• A healthy Q4 GDP reading and improving consumer sentiment reinforced sentiment of solid but slowing economic growth.

Core PCE, Fed minutes send rates to recent highs

• The Treasury sell-off continued in earnest last week after the FOMC’s February meeting minutes, and the latest core PCE reading suggested that the Fed would hold the key policy rate “higher for longer” to bring decades-high inflation back to levels consistent with their stated average 2% target.
• According to the Commerce Department, the Fed’s preferred measure of inflation, core PCE, rose 0.6% in January, more than the 0.4% consensus expectation and the 0.3% increase experienced in December.
• February has marked a broad shift in market sentiment as market participants have scaled back on their bets for rate cuts in the latter half of the year amid several upward surprises to inflation and employment figures.
  • The rate moves since the turn of February have been head-turning, with the 2-year Treasury rising an impressive 69 basis points to 4.78% and the 10-year Treasury rising a robust 56 basis points to 3.95% month-to-date.
• The minutes of the FOMC’s latest meeting suggested that the FOMC plans to keep its foot on the pedal through 2023, although at a slower pace than in 2022.
  • Consistent with commentary offered by Fed officials in recent weeks, “almost all” officials agreed that a 25bp hike was the correct magnitude increase, with “a few” officials preferring a 50bp rise like in December.
• Looking at Fed Funds futures pricing at the week’s end, near-term policy rate expectations remain roughly unchanged as market participants continue to expect 25 basis point rate hikes at the March, May, and June policy meetings.
  • Notably, market participants slashed odds for rate cuts in 2023 and currently expect that rate cuts will start in 2024 rather than in 2023, as previously expected.

Asset-sensitive hedging strategies return

• After experiencing a wave of rising rate hedges to start the year, strategies to protect against falling rates gained steam in the last two weeks as rates increased across the curve and the cost to hedge for falling rates decreased.
• Specifically, we have seen increased use of option products, with asset-sensitive clients utilizing costless collars and floor spreads to achieve their desired level of falling rate protection while limiting the downside in a rising rate environment relative to an interest rate swap.
  • Most of these hedges have been pointed to the floating rate loan portfolio to achieve the favorable hedge accounting treatment. In many cases, the back-to-back swap portfolio can be a great host for a targeted balance sheet hedge, given the homogeneity often exhibited in those portfolios.
• Nonetheless, we continue to see many institutions lock in the cost of new wholesale funding creating a synthetic fixed rate borrowing structure for term, but at a cheaper cost than can be obtained at the FHLB or in the brokered markets.

Rising funding costs set to continue amid deposit outflows

• As evidenced in the many Q1 earnings calls in recent weeks and by the hedging activity we have seen crossing our balance sheet strategies desk, competition for deposits is heating up, and wholesale funding needs are increasing significantly across the banking space.
• In aggregate, the U.S. banking space has seen three consecutive quarters of deposit outflows, with $166.38 billion of sequential deposit declines recorded in the fourth quarter, according to an analysis conducted by S&P Capital IQ.
• Despite the run-up in rates throughout 2022 and the expected end to the Fed’s hiking campaign nearing, many bank executives expect deposit outflows and deposit competition to increase in the coming quarters.
  • Speaking at a conference earlier this month, JPMorgan CFO Jeremy Barnum highlighted his expectation for continued deposit outflows and rising funding costs emphasizing that “the question is really about the lags.”

Fourth-quarter GDP, consumer sentiment releases suggest economic strength

• Although last week’s economic releases included a few soft spots, economic data has generally pointed to a solid U.S. economy, outside of the manufacturing industry, in recent weeks.
• The Commerce Departed reported Thursday that the U.S. economy expanded at a 2.7% annualized pace in the fourth quarter, slightly slower than the 2.9% initial estimate and the 3.2% pace seen in the third quarter.
  • Looking ahead, the Atlanta Fed forecasts the U.S. economy to expand at an unchanged 2.7% annualized pace in the first quarter.
• Finally, the University of Michigan’s consumer sentiment index, released Friday, topped the consensus expectation and the prior month’s reading rising to 67.0 in February, the best reading in a year amid falling near-term consumer inflation expectations.
  

The look forward

Upcoming economic data releases

• Durable Goods Orders – Monday
• Dallas Fed Manufacturing Activity Index – Monday
• Wholesale Inventories – Tuesday
• MNI Chicago PMI – Tuesday
• Richmond Fed Manufacturing Index – Tuesday
• Conference Board Consumer Confidence Index – Tuesday
• MBA Mortgage Applications – Wednesday
• S&P Global Manufacturing PMI – Wednesday
• ISM Manufacturing Index – Wednesday
• Jobless Claims – Thursday
• S&P Global Services / Composite PMIs – Friday
• ISM Services Index – Friday

Upcoming Federal Reserve Speakers

• Jefferson – Monday
• Goolsbee – Tuesday
• Kashkari – Wednesday
• Waller, Kashkari – Thursday
• Logan, Bostic, Bowman – Friday
• Daly – Saturday

Rates snapshot

Market implied policy path (overnight indexed swap rates)