Skip to main content
Market Update

Hotter-than-expected inflation sends rates higher

Date:
September 19, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

The Treasury selloff intensified last week as investors recalibrated their bets for Federal Reserve policy action in the near term after the latest inflation readings showed prices accelerating faster than expected.

Interest rates

  • In an exceptionally volatile week, Treasury yields across the curve moved substantially higher as market participants priced in their expectations for an even more aggressive Federal Reserve after the August inflation reports showed that prices remain significantly elevated.
    • The two-year Treasury yield climbed 29 basis points over the week to 3.85%, the highest level since 2007, while the 10-year yield increased 12 basis points to 3.45%.
  • After steepening for much of September, the curve flattened notably last week on the back of outsized moves at the front end of the curve relative to moves at the long end.
    • The 2s/10s basis gave up its September gains last week compressing a substantial 17 basis points to -0.43% and touching the multi-decade lows previously reached in mid-August.
  • Despite Federal Reserve officials abstaining from speaking engagements until after the September 20-21 FOMC meeting, investors still meaningfully altered their expectations for FOMC policy action in the next six months.
    • Investors have now fully priced in a 75 basis point hike for this week’s FOMC policy meeting and see a roughly 25% chance that the FOMC levies an even larger 100 basis point hike at the conclusion of Wednesday’s meeting.
    • In aggregate, market participants now expect the Fed to raise the Target Rate 2.25% from current levels by the end of the first quarter 2023, 25 basis points higher than last week’s expectation and 50 basis points more than investors were pricing in at the start of September.
  • Inflation expectations at all of the major tenors continue to experience notable declines.
    • The Fed-preferred measure of inflation expectations, the five-year forward, five-year breakeven inflation rate, fell eight basis points to 2.21%, just below the yearly average and equivalent to levels seen at this time last month.
    • The rise in nominal rates coupled with the decline in inflation expectations saw real yields across the curve also move higher.
      • The five-year and 10-year real yields both crossed over the psychologically-significant 1% level to end the week at 1.13% and 1.07%, respectively.

    Trading commentary

    • Elevated interest rate volatility continued to drive hedging activity across our client base last week.
    • While the majority of clients are executing hedges designed to protect against a downturn in interest rates, last week, we saw a balanced level of activity in both directions as clients look to fine-tune their sensitivities in the face of significant volatility and uncertainty.
    • As we have noted in the past, we have seen an increase in the deployment of strategies designed to lock in or cap the cost of wholesale funding.
      • Last week, we saw clients execute pay-fixed swaps to extend the duration of short-term advances from the Federal Home Loan Bank.
      • While most of the wholesale funding hedges to date have been executed in the three- to five-year part of the curve, we have seen a notable rise in executions at the very front-end of the curve in recent weeks.
    • Nonetheless, we continue to see clients extend duration on the asset side of the balance sheet, utilizing receive-fixed swaps, zero-cost collars, and floor spreads, to mitigate asset sensitivity and protect against a decline in rates.

      Big banks report slowing loan growth

      • Several executives of large U.S. financial institutions spoke to the media last week at an investor conference and offered their thoughts on the current state of the industry.
      • Loan growth has picked up in 2022 relative to the year prior, but many executives are expecting growth in the second half of the year to slow from levels seen in the first half.
        • Executives at Bank of America, Regions Financial Corp., Wells Fargo, and Truist, among others, all reported that loan growth has moderated in the third quarter.
      • Many executives gave positive outlooks for net interest income growth in the coming quarter however highlighting the impact of realized and expected Fed rate hikes.

        Economic data

        • While the economic calendar was packed with high-profile updates last week, the majority of investor attention was directed at the inflation readings of the Consumer Price Index (CPI) and the Producer Price Index (PPI).
        • According to the Labor Department, consumer prices rose at a 0.1% pace last month, defying analysts’ expectations for a decline and topping the neutral reading seen in July.
          • Yearly, CPI rose 8.3% in August, down from both the 8.5% reading in July and the multi-decade high of 9.1% reached in June but substantially above historical norms.
          • The pick-up in the monthly reading, particularly the core level, sent rates significantly higher as the hope for a substantial easing of inflationary pressures faded and investors became more convicted of a persistently hawkish Federal Reserve.
        • Wednesday’s PPI reading further reinforced the market’s expectation for a hawkish Federal Reserve as August core PPI matched the consensus expectation, declining 0.1% month-over-month.
        • Last week’s manufacturing data painted a mixed picture of the industry.
          • The regional Empire Manufacturing Index performed much better than expected, recovering from the substantial drop in activity seen in August on the back of improving levels of new orders and shipments.
            • Encouragingly, both the prices paid and prices received components of the report declined substantially, offering some solace from the hotter-than-expected inflation readings seen earlier in the week.
          • The Philadelphia Fed Business Outlook Survey showed weakness, however, as the Survey reading indicated a slowdown from August’s activity,
        • Finally, retail sales provided a bright spot near the end of the week, rising 0.4% in August, well above analysts’ expectations and the flat reading seen in July.

          The look forward

          Upcoming economic data releases

          • Housing Starts - Tuesday
          • Building Permits - Tuesday
          • FOMC Rate Decision - Wednesday
          • Existing Home Sales - Wednesday
          • Jobless Claims - Thursday
          • Leading Index - Thursday
          • S&P Global Manufacturing / Services PMI - Friday

          Upcoming Federal Reserve speakers

          • Powell - Wednesday
          • Powell - 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.

          22-0249