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Market Update

FOMC raises target range 50 basis points

Date:
May 9, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

In another eventful week packed with a full economic calendar and a high-profile monetary policy meeting, the Treasury curve steepened significantly with the 10-year Treasury yield exceeding 3% for the first time since 2018 as investors grappled with the implications of higher rates for both the inflation and growth outlook.

Interest rates

  • After flattening the week prior, the Treasury curve steepened last week to levels not seen since mid-April.
    • The 10-year Treasury yield ended the week at 3.12%, while the 2s/10s basis widened nearly 20 basis points to 0.39%.
  • Last week’s moves came as investors digested the results of the FOMC monetary policy meeting and the latest commentary from Federal Reserve Chair Jerome Powell.
    • As expected, the FOMC opted to raise the target range 50 basis points to 0.75% - 1%, marking the largest single-meeting increase since 2000.
  • During the press conference following the decision, Chair Powell indicated that 50 basis point hikes are “on the table for the next couple of meetings,” but threw cold water on the prospects for an even greater 75bps increase commenting that such a move is “not something that the committee is actively considering.”
  • As of Friday’s close, the Fed Funds futures market is fully pricing in 50 basis point moves at the June and July FOMC meetings but is largely taking Powell’s comments at face value with only a 15% chance of a 75bps hikes priced in for the next monetary policy meeting.
  • Last week’s run-up in long-term rates drove real yields notably higher.
    • The 10-year Treasury real yield rose 25 basis points to 0.26%, while the seven-year real yield entered positive territory for the first time since March 2020, ending the week at 0.07%.
  • Finally, despite the run-up in mid and long-term rates last week, inflation expectations moved lower with the five-year and 10-year breakeven inflation rates finishing the week approximately 15 and 10 basis points lower, respectively.

                  Trading commentary

                  • Our balance sheet desk remained busy last week and saw significant hedging activity in both directions.
                    • Continuing with the down-rate hedging theme that we have commented on previously, we continue to see clients look to extend the duration of assets and smooth earnings with receive-fixed swaps pointed at the floating-rate loan book.
                      • Notably, we saw the first CME Term SOFR receive-fixed swap executed on our balance sheet hedging desk as clients continue to build up volume on the new index.
                    • Similarly, we have seen clients unwind existing pay-fixed swaps that were executed in 2020 and 2021 and were hedging the AFS securities portfolio.
                    • Looking at current market pricing, a five-year SOFR-OIS receive-fixed swap offers roughly 200 basis points of initial compensation at inception.
                  • Looking at rising rate hedging activity, trades hedging expected wholesale funding remains popular as clients execute six-18 month forward-starting pay-fixed swaps to lock in the cost of future wholesale funding.
                  • Hedging activity on our back-to-back trading desk remained robust last week, with clients eager to lock in the cost of long-term financing.
                    • Following Wednesday's Fed announcement, we saw an increase in back-to-back swap terminations with borrowers in asset positions.
                    • Consistent with the activity we have seen over the last few weeks, we have seen an increase in clients re-indexing current LIBOR loans to float on CME Term SOFR.

                                  U.S. Financial Institutions report OCI degradation in the first quarter

                                  • With the sharp increase in rates across the curve since the turn of the year, it is not a surprise that many U.S. financial institutions are experiencing heartburn from the Other Comprehensive Income (OCI) degradation experienced from the decline in the AFS securities portfolio.
                                  • According to S&P Capital IQ, the 15 largest U.S. financial institutions reported a $46.62 billion decline in OCI in the first quarter amidst the sharp rise in rates precipitated by the expectation for an aggressive Fed hiking cycle.
                                    • The possibility of further OCI degradation has precipitated many conversations on our balance sheet desk as clients evaluate the trade-offs between hedging rising-rate exposure with pay-fixed swaps and caps against alternatives such as moving securities to HTM.

                                                                Economic data

                                                                • Although the week’s economic data releases largely played second fiddle to the highly anticipated FOMC monetary policy meeting, investors were on high alert for the latest labor market readings.
                                                                • According to the Bureau of Labor Statistics, the U.S. economy added 428,000 jobs in April, modestly above the consensus estimate and unchanged from the downwardly revised March reading.
                                                                  • Looking deeper into the report, the unemployment rate remained unchanged at 3.6%, and wage pressures showed some signs of easing as average hourly earnings rose 0.3% in April compared to the upwardly revised 0.5% increase seen in March.
                                                                • While the release was viewed positively by most analysts, Friday’s solid gains in the nonfarm payroll report were clouded somewhat by the weaker-than-expected ADP employment report, released earlier in the week, that showed private payrolls adding 247,000 jobs in April, far short of the 479,000 private job additions reported in March.

                                                                  The look forward

                                                                  Upcoming economic data releases

                                                                  • Wholesale Inventories - Monday
                                                                  • Consumer Price Index - Wednesday
                                                                  • Producer Price Index - Thursday
                                                                  • Jobless Claims - Thursday
                                                                  • University of Michigan Consumer Sentiment Index - Friday

                                                                                                    Upcoming Federal Reserve speakers

                                                                                                    • Williams, Barkin, Waller, Mester, Bostic - Tuesday
                                                                                                    • Bostic - Wednesday
                                                                                                    • Daly - Thursday
                                                                                                    • Kashkari, Mester - Friday

                                                                                                                                      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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                                                                                                                                      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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