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Market Update

Hawkish Fed minutes send rates higher

Date:
January 10, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

In a volatile start to the new year, the major U.S. equity indices fell from record highs with the Nasdaq Composite Index recording its worst weekly close in nearly a year. Bonds across the curve sold off as investors pulled forward expectations for the start of the rate hiking cycle and priced in a quicker start to a Fed balance sheet reduction program.

Economic data

  • Market participants were the beneficiaries of several high-profile data releases last week, with most updates focusing on manufacturing activity or the labor market.
  • After a collection of regional manufacturing indices painted a mixed picture of manufacturing activity in recent weeks, the ISM Manufacturing Index also offered a mixed bag on Tuesday, falling slightly from November’s reading but remaining well within expansionary territory.
    • While December’s reading was the lowest in nearly a year, market participants took plenty of positives from the report as it appeared both supply chain constraints and price pressures were easing in the final month of the year.
    • Digging into the report, the six largest manufacturing industries measured in the index reported “moderate-to-strong” growth in December on the back of a robust level of both new orders and production.
    • Notably, supply chain constraints started to ease as delivery times fell substantially month-over-month and the prices paid component fell 14.2% in December.
    • While many aspects of the report appeared positive, analysts were quick to warn that those supply chain improvements would likely prove short-lived as the latest report does not fully reflect the impact of the recent holiday season COVID-19 surge experienced globally.
  • Meanwhile, investors turned much of their attention to the labor market on the back half of the week as both the ADP employment report and the December non-farm payroll report were released last week.
    • According to ADP, U.S. private payrolls recorded a strong 807,000 job additions in December, smashing expectations and notching the highest monthly gain since May 2021.
    • However, labor market optimism diminished on Friday somewhat when it was reported that the U.S. economy added 199,000 non-farm jobs in December, the third miss in five months and well below the 450,000 consensus expectation.
    • While the headline figure appeared weak, investors looked to a pickup in average hourly earnings and a decline in the unemployment rate to 3.9%, a pandemic-era low, as evidence of a tight and improving labor market.
    • Finally, both the October and November job totals were revised higher for a net 141,000 additional job gains.

                FOMC Minutes reinforce hawkish December meeting tone

                • According to the minutes of the high-profile December FOMC meeting, released Wednesday, the FOMC discussed plans for paring back the substantial support given to financial markets since the onset of the pandemic nearly two years ago.
                  • Specifically, officials discussed shrinking the nearly $8.3 trillion portfolio of Treasuries and mortgage-backed securities that the Federal Reserve holds on its balance sheet as, “almost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate.”
                  • With the labor market tightening and consumer prices on the rise, financial markets are pricing in the first rate hike in March, suggesting that the Fed balance sheet could start shrinking before the summer begins.
                  • Of note, officials also commented that the speed at which they shrink the balance sheet “would likely be faster than it was during the previous normalization episode” that started in 2017.
                • Speaking at an event on Thursday, St. Louis Federal Reserve President James Bullard suggested that the first rate hike could come as early as March “in order to be in a better position to control inflation” with subsequent rate hikes dependent on changes to the inflationary environment.
                • Looking at the calendar, market participants will not need to wait long for more answers as the next FOMC monetary policy meeting is held in just over two weeks on January 25-26.

                      Interest rates

                      • Treasury yields across the curve moved substantially higher over the week as the hawkish FOMC minutes coupled with an improving manufacturing industry and a tightening labor market drove the 10-year Treasury as high as 1.80%, a level not seen since March 2020.
                      • With Fed balance sheet runoff discussions having taken place and several FOMC officials suggesting a March rate hike is a possibility, market participants pulled forward expectations for Fed rate hikes, sending short-term and long-term rates alike notably higher.
                        • Specifically, markets are pricing in the chance of a March rate hike north of 85% with a second hike coming in June or July, and a third hike in November or December.
                        • The market’s expectation for three rate hikes in 2022 now aligns more closely with the Fed’s latest Summary of Economic Projections, where most officials forecasted three hikes for 2022.
                      • Looking at the curve after last week’s moves, the curve is decidedly steeper, with the 2s/10s basis rising approximately 13 basis points to 0.90%.
                      • Notably, the pickup in Treasury yields was not driven by increased inflation expectations as the five-year breakeven inflation rate fell seven basis points over the week to 2.83%.
                      • Turning our attention to the derivatives markets, we have seen an increase in down-rate hedging inquiries as the relative compensation for entering into one of these transactions has increased meaningfully to start the year.
                        • Using the five-year point as an example, a five-year Fed Funds interest rate swap currently offers approximately 126 basis points of initial positive carry, up 21 basis points from just one month ago.

                                  SOFR volumes gain ground against LIBOR at year-end

                                  • Since the launch of the SOFR First initiative last summer, SOFR derivative volumes have increased substantially in both absolute notional volume and relative to LIBOR.
                                  • Looking at the final week of 2021, approximately 3,000 SOFR derivatives were executed, with a total notional of $253.1 billion.
                                    • While the final week of the year’s activity was significantly depressed from the nearly $600 billion in SOFR trading seen just before the holiday season, SOFR notional volume relative to LIBOR notional volume has been on the rise significantly in recent months.
                                    • Looking at last week’s data, SOFR derivative notional amounted to roughly 60% of LIBOR notional volumes, the highest SOFR/LIBOR notional ratio seen to date.

                                  The look forward

                                  Upcoming economic data releases

                                  • Wholesale inventories – Monday
                                  • Consumer Price Index – Wednesday
                                  • Producer Price index – Thursday
                                  • Jobless Claims – Thursday
                                  • Retail Sales – Friday
                                  • Industrial Production – Friday

                                        Upcoming Federal Reserve Speakers

                                        • Mester, George – Tuesday
                                        • Kashkari – Wednesday
                                        • Barkin, Evans – Thursday
                                        • Williams – 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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