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Market Update

FOMC hikes another 75 basis points; Q2 GDP contracts

Date:
August 1, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

Treasury yields across the curve took another leg lower last week, the third consecutive weekly decline, as investors grappled with a weak Q2 GDP reading, a slightly-more-dovish-than-expected FOMC, and strong earnings from the biggest tech corporations.

Interest rates

  • The Treasury curve, as measured by the 2s/10s basis, compressed modestly to negative 25 basis points last week as both the 2-year and 10-year Treasury yields declined roughly 10 basis points on the week.
    • The sustained inversion of the Treasury curve has caused some head turning as an inversion typically precedes a recession.
    • Although the curve inverted in 2019 and in the lead-up to the Great Recession, the 2s/10s basis has not inverted greater than 20 basis points since the fall of 2000 during the Dot-com bubble.
  • In a widely expected move, the FOMC increased the Target Range by 75 basis points on Wednesday to 2.25%–2.50%, notching its highest level since the summer of 2019.
    • While the FOMC has raised rates by 225 basis points since the turn of the year, current market pricing suggests that Fed policymakers will increase the Target Range another 100 basis points by year-end before calling it quits on this tightening cycle.
    • Notably, Fed Chair Jerome Powell signaled that he and his colleagues at the Fed will offer less guidance on the size of future rate hikes going forward and indicated that the size of the coming rate hikes will be data dependent.
    • Looking at Fed Funds futures pricing at Friday’s close, market participants currently expect a 50-basis-point hike at the next meeting in September.
  • Finally, inflation expectations moved notably higher last week sending real yields lower.
    • The 5-year real yield dropped a sizeable 34 basis points last week, falling back into negative territory at -0.03%.

Trading commentary

  • Activity has remained elevated well into the third quarter on our balance sheet risk management desk.
  • As noted previously, we continue to see the lion’s share of hedging activity in strategies that protect against a downturn in interest rates.
    • While a plain vanilla receive-fixed interest rate swap has been the most oft-used derivative product when implementing these strategies, our desk has seen a notable rise in option-based products, particularly zero-cost collars, in recent weeks.
    • To date, most clients have leveraged their commercial-real estate-focused 1-month LIBOR portfolios as the hedge vehicle, but several clients have opted to bypass the nuances associated with the LIBOR transition and look to Prime or Term SOFR-based loan portfolios to also achieve favorable hedge accounting treatment.
  • While hedging volume in strategies that protect against further increases in rates has decreased in recent months, we continue to see clients execute strategies designed to lock in the cost of long-term fixed-rate financing from the FHLB.
    • Using a pay-fixed SOFR swap coupled with a short-term SOFR-based advance, we have assisted clients in synthetically creating a fixed-rate funding profile, often beating the fixed-rate alternative offered at the FHLB by 20–50 basis points.

Chair Powell sends bank stocks higher

  • The more-dovish-than-expected press conference from Fed Chair Jerome Powell sent bank stocks higher as Powell backed a series of additional hikes but cautioned that the Committee will also pause in time to assess the cumulative impact of rate increases on the broader economy.
  • The Fed’s action since the turn of the year has been a boon to many financial institutions across the country as both short and long-term rates have risen considerably but deposit costs have remained relatively flat.
    • With the second-quarter earnings season in full swing, we have heard many U.S. financial institutions express optimism for full year 2022 and 2023 net interest income growth citing the pick-up in interest rates.

Economic data

  • Market participants received many high-profile updates from a packed economic calendar last week.
  • The manufacturing and housing industry outlooks continued to worsen after two more regional manufacturing surveys indicated neutral or contracting activity and new home sales dropped below both the consensus estimate and levels seen in May.
  • Consumer confidence appears to be holding steady after declining substantially since the turn of the year.
    • The Conference Board Consumer Confidence Index moved modestly lower, while the University of Michigan’s Consumer Sentiment Index inched modestly higher.
  • All eyes were on the second quarter GDP report released Thursday.
    • According to the Commerce Department, the U.S. economy contracted at a 0.9% annualized pace in the second quarter, far below the consensus estimate but modestly above the -1.6% annualized pace seen in the first quarter.
    • The negative Q2 figure represents the second consecutive quarter of negative GDP growth, a common definition for an economy in a recession.
    • Looking ahead, the Atlanta Fed’s GDPNow tool, which attempts to forecast the current quarter’s GDP in real-time, predicts the U.S. economy will return to growth in the third quarter and post a 2.1% gain.

The look forward

  • Upcoming economic data releases
    • S&P Global US Manufacturing PMI – Monday
    • Construction Spending – Monday
    • ISM Manufacturing Index – Monday
    • S&P Global Services / Composite PMI – Wednesday
    • Durable Goods Orders – Wednesday
    • Factory Orders – Wednesday
    • ISM Services Index – Wednesday
    • Jobless Claims – Thursday
    • July Non-Farm Payroll Report – Friday
  • Upcoming Federal Reserve Speakers
    • Evans, Mester, Bullard – Tuesday
    • Mester – 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

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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