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Market Update

FOMC raises Target Range 75 basis points

Date:
June 21, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

After moving significantly higher on the back of a hotter-than-expected inflation reading the week prior, Treasury yields remained very volatile throughout the week and ended the week moderately higher across the curve as investors grappled with the FOMC’s decision to raise the Target Range 75 basis points and the fear of an impending global economic slowdown.

Interest Rates

  • While volatility has been elevated for much of the year, last week’s yields were exceptionally volatile with the 10-year Treasury rising as high as 3.49%, the highest level since April 2011, before falling to 3.25% to end the week.
  • Yields across the curve moved notably higher to start the week as investors continued to react to the previous Friday’s inflation data and priced in the expectation for a 75 basis point hike over the 50 basis point move expected the week prior.
    • While a 75-basis point hike was fully priced in by the time of the June 15 FOMC monetary policy meeting decision, the change in expectations was rapid as market participants placed only a 25% chance for such a move on the previous Friday.
    • After the FOMC rose the Target Range by 75 basis points to 1.50% - 1.75%, market participants are now expecting an additional 200 basis points in rate hikes by the end of 2022, 25 basis points more than the previous week’s expectation.
  • Although inflation expectations rose after the CPI release, both medium-term and long-term inflation expectations moved lower during the week, with the five-year breakeven inflation rate ending Friday at 2.84%, roughly five basis points below the yearly average.
  • Finally, real yields accelerated considerably last week with the five-year real yield breaking 42 basis points higher over the week and currently standing at 0.50%, while the 10-year real yield moved a more modest but still robust 21 basis points to 0.79%.

    Trading commentary

    • Hedging activity has continued at a blistering pace across our balance sheet risk management desk as clients evaluate their risk profiles and look to protect against the downside.
    • As noted previously, most activity crossing our desk has been geared toward hedging a downturn in interest rates.
      • Many of our asset-sensitive clients have looked to pull income forward in the expected rising rate environment and prepare their institutions for a declining interest-rate environment by executing primarily receive-fixed interest rate swaps and interest rate collars.
      • Most clients have opted to hedge existing one-month LIBOR-based exposure with SOFR swaps, while others have opted to bypass the LIBOR transition and execute Prime-based derivatives against Prime floating rate loans, primarily the HELOC portfolio.
      • We continue to see clients who executed pay-fixed swaps in 2020 and 2021 unwind those transactions at substantial gains.
    • Although downrate hedging strategies have been the most popular across our client base in recent weeks, we continue to see clients executing pay-fixed swaps, locking in wholesale funding at current levels, or using the investment portfolio to hedge the balance sheet against further OCI degradation.
    • Finally, our back-to-back trading desk remains active as clients look to lock in long-term fixed-rate financing, while others look to amend existing derivative contracts from LIBOR to alternative indices, primarily CME Term SOFR.

      Big banks signal a slowdown in CRE is coming

      • Big bank executives and analysts alike have warned that CRE portfolios may see growth slowdown as rates rise and demand from both borrowers and lenders decline.
        • Both U.S. Bank and KeyBank have expressed optimism about the multifamily and industrial segments’ prospects for the year, but have indicated that they expect the office space segment to face headwinds with U.S. Bank CFO Terrance Dolan saying, “With return-to-the-office still, I think, in a nascent sort of stage, we want to see how that develops over time,” and KeyBank Chairman, President and CEO Christopher Gorman signaling that he thinks the segment is “vulnerable.”
        • Nonetheless, at an investor conference last week, executives at many of the largest U.S. financial institutions expressed optimism about the economic outlook, highlighting the resilience of the consumer and strong credit performance across the industry.

        Economic data

        • While last week’s FOMC monetary policy meeting garnered much attention from market participants last week, investors also digested a hefty economic calendar.
        • Tuesday marked the release of the May Producer Price Index (PPI) report and indicated that prices accelerated 0.8% over the month, in line with expectations but far quicker than the 0.5% pace seen in April.
          • Investors let out a small sigh of relief however when the PPI yearly figure showed a slight easing in producer price pressures increasing 10.8% compared to the 11% year-over-year figure reported for April.
        • Two regional manufacturing surveys pointed to a weakening manufacturing outlook as both the Empire Manufacturing Index and the Philadelphia Fed Business Outlook Survey dropped below expectations and fell into contractionary territory.
          • Notably, both indices reported a pickup in producer prices as supply chain constraints continue to lead toward higher prices.
        • Finally, retail sales, which are not inflation-adjusted, defied calls for a modest gain and instead contracted 0.3% in May, far below the 0.9% gain seen a month earlier.

          The look forward

          Upcoming economic data releases

          • Chicago Fed National Activity Index - Tuesday
          • Existing Home Sales - Tuesday
          • Jobless Claims - Thursday
          • S&P Global US Manufacturing / Services PMI - Thursday
          • University of Michigan Consumer Sentiment - Friday
          • New Home Sales - Friday

                                                      Upcoming Federal Reserve speakers

                                                      • Barkin, Mester - Tuesday
                                                      • Powell, Barkin, Evans, Harker - Wednesday
                                                      • Powell - Thursday
                                                      • Bullard, Daly - 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

                                                        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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