Inflation cools, rates drop

Yields fall as inflation cools

• Treasury yields fell substantially across the curve last week following weaker-than-expected Consumer Price Index (CPI) and Producer Price Index (PPI) releases.

Hedging activity increases in Q3

• Hedging activity has continued at a brisk pace in the third quarter as our clients looked to fine-tune their risk positions in a historically volatile interest rate environment.

Inflation eases, consumer sentiment improves

• Last week’s release of the June CPI and PPI figures grabbed the lion’s share of investors’ attention and dominated financial market headlines.

Yields fall as inflation cools

• Treasury yields fell substantially across the curve last week following weaker-than-expected Consumer Price Index (CPI) and Producer Price Index (PPI) releases.
• The 2-year fell 20 basis points to 4.74%, while the 10-year dropped an even greater 23 basis points to 3.83%.
• The moderately steeper decline at the long end drove the 2s/10s basis roughly three basis points lower to -0.91%, far below the year-to-date average of -0.72%.
• The FOMC appears ready to hike the policy rate another 25 basis points at the end of the month.
• Several officials held speaking engagements during the week and most suggested that the FOMC needs to do more to combat inflation, although some argued that the committee should "wait and see."
• Fed Governor Christopher Waller advocated for two more 25 basis point hikes in 2023 and saw "no reason why the first of those two hikes should not occur at our meeting later this month," while San Francisco Fed President Mary Daly expressed a similar preference but noted that the inflation readings were "very positive."
• Nonetheless, some officials preferred another pause, with Atlanta Fed President Raphael Bostic arguing that "our policy right now is clearly in the restrictive territory" and that the economy continues to show signs of "slowing down."
• While there is some disagreement among officials about the action to take at the next FOMC meeting, market participants are placing a near-certain probability of the FOMC raising the target range at the end of the month.
• According to the latest Fed Funds futures pricing, market participants see the probability of a 25 basis point rise at the conclusion of the July FOMC meeting at 93%.
• Although there is conviction in the market around the next meeting's outcome, the outlook becomes much murkier for the rest of the year, with investors currently pricing in July’s anticipated hike as the final hike in the FOMC’s historic tightening campaign.
• Despite the higher-for-longer narrative pushed by the Fed and the recently released dot plot indicating an expectation for a modest level of interest rate cuts in 2024, market participants are currently pricing in an aggressive easing campaign in 2024, with market pricing suggesting the FOMC will slash rates approximately 150 basis points through 2024.
• All eyes will be on the FOMC at the end of the month, with the next policy meeting scheduled for July 25-26.

Hedging activity increases in Q3

• Hedging activity has continued at a brisk pace in the third quarter as our clients looked to fine-tune their risk positions in a historically volatile interest rate environment.
• Our liability-sensitive clients continue to explore and execute hedging strategies that protect against a rising interest rate environment, and last week we saw many clients capitalize on the decline in rates following lower-than-expected inflation releases.
• Most of this hedging activity has been focused on the 2-3-year range and has leveraged either the fixed-rate asset portfolio or traditional wholesale borrowing programs to receive favorable hedge accounting treatment.
• As mentioned previously, we have seen a notable rise in asset-sensitivity hedging recently as rates have climbed in the last two months and the relative attractiveness of these strategies has improved substantially.
• Clients have most commonly leveraged homogenous floating-rate asset portfolios in these strategies, but we have seen clients increasingly explore the utilization of long-term fixed-rate wholesale borrowings and retail certificates of deposit.
• Although plain vanilla interest rate swaps are historically the most common product utilized, recently, we have seen most asset-sensitive hedging strategies deploy interest rate floors and costless collars.

Inflation eases, consumer sentiment improves

• Last week’s release of the June CPI and PPI figures grabbed the lion’s share of investors’ attention and dominated financial market headlines.
• According to the Commerce Department, headline CPI fell to 3.0% in June from one year ago, modestly below expectations but substantially below the 4.0% pace reported in May.
• Treasury yields dropped notably on the back of the report as investors grew more confident that the Fed is nearing the end of its tightening campaign.
• PPI offered similar results, reporting an increase of just 0.1% in June from one year ago, notably below the 1.1% pace reported in May.
• Consumer sentiment is improving, according to the latest University of Michigan report.
• According to the release, consumer sentiment improved to 72.6 in July, up from the 64.4 level reported a month earlier as gauges of current economic conditions and the near-term outlook improved from June.
• Interestingly, consumer expectations for inflation in the next year and the long term increased relative to June and resided in the low 3.0% range.

The look forward

Upcoming economic data releases

• Empire Manufacturing Index – Monday
• Retail Sales – Tuesday
• Industrial Production – Tuesday
• MBA Mortgage Applications – Wednesday
• Housing Starts – Wednesday
• Building Permits – Wednesday
• Jobless Claims – Thursday
• Philadelphia Fed Business Outlook Survey – Thursday
• Existing Home Sales – Thursday
• Leading Index – Thursday

Upcoming Federal Reserve Speakers

• Barr, Gibson – Tuesday

Rates snapshot

Market implied policy path (overnight indexed swap rates)