Inflation data, Fed officials add fuel to Treasury sell-off

Highlights in this week's market update

Fed officials signal 50bp hike possibility

• While most officials only went as far as to say that the policy rate will need to reach higher than current levels to combat inflation appropriately, St. Louis Fed President James Bullard and Cleveland Fed President Loretta Mester turned heads and sent rates higher on Thursday after they both opened the door to a 50 basis point hike at the next FOMC meeting in March.

Hedging activity continues to balance in ‘23

• After seeing most hedging strategies prepare for a declining rate environment in 2022, we have seen a substantial rise in strategies designed to protect against further increases in interest rates as clients’ needs for wholesale borrowings increase.

C&I growth gives boosts to U.S. community banks

• Despite headwinds from higher rates, multifamily and commercial and industrial (C&I) lending grew moderately in the fourth quarter.

Inflation data tops expectations

• CPI and PPI each topped the consensus estimate in January despite continuing to decline on a yearly basis.

Fed officials signal 50bp hike possibility

• Many Federal officials held speaking engagements last week, and most officials communicated a need to continue to raise interest rates and potentially to levels higher than “previously anticipated.”
• While most officials only went as far as to say that the policy rate will need to reach higher than current levels to combat inflation appropriately, St. Louis Fed President James Bullard and Cleveland Fed President Loretta Mester turned heads and sent rates higher on Thursday after they both opened the door to a 50 basis point hike at the next FOMC meeting in March.
  • Specifically, Bullard emphasized the Fed would need to show “inflation-fighting resolve” throughout 2023 and highlighted that he was in support of a 50 basis point hike at the FOMC’s last meeting and that he “wouldn’t rule anything out” for future meetings, including the FOMC’s mid-March meeting.
  • Mester suggested she saw “a compelling economic case” for a 50bp hike at the last meeting and that recent developments have not changed her view that the FOMC needs to bring the policy rate “above 5% and hold it there for some time.”
• Looking at Fed Funds futures pricing on Friday, market participants see a 15% chance of a 50bp hike at the March meeting.
  • While the probability of a 50bp hike remains slim according to current market pricing, the likelihood of such a hike is roughly three times greater than market pricing suggested only one week ago.

Hedging activity continues to balance in ‘23

• Hedging activity remained robust last week as we continue to see more balanced activity levels across the client base in aggregate.
• After seeing most hedging strategies prepare for a declining rate environment in 2022, we have seen a substantial rise in strategies designed to protect against further increases in interest rates.
  • Many clients have reported deposit outflows that have exceeded their expectations and a newfound reliance on wholesale funding.
  • This new dynamic has driven many U.S. financial institutions to explore and deploy hedging strategies that lock in or cap the cost of wholesale borrowings.
• The uncertainty of the current rate environment and the path forward has also influenced the decision-making process of many commercial borrowers using interest rate derivatives.
  • Back-to-back programs continue to see contrasting expectations from borrowers. Many have elected to hedge only the first few years of their debt or consider more customized structures like forward-starting swaps and partial hedges on the popular belief that rates will come down later this year. At the same time, other borrowers have elected to hedge long term on the fear that rates will continue to rise. It remains to be seen how this dynamic may change given the recent climb in rates and altered sentiment about the Fed’s path forward.

C&I growth gives boost to U.S. community banks

• According to an analysis conducted by S&P Capital IQ, U.S. community banks experienced a 3% sequential increase in loan balances in the fourth quarter.
  • Despite headwinds from higher rates, multifamily and commercial and industrial (C&I) lending picked up 3.0% and 3.1%, respectively.
  • Loan growth in the fourth quarter was widespread, with 18 of the 20 largest U.S. community banks reporting loan growth quarter-over-quarter.

Inflation data tops expectations

• Despite a robust economic calendar last week, the twin inflation measures, Consumer Price Index (CPI) and Producer Price Index (PPI), garnered the most attention from market participants.
• According to the Commerce Department, consumer prices rose 0.5% in January and 6.4% in the last year, slightly exceeding consensus expectations.
  • The 0.5% increase in January, while broadly in line with market expectations, marks a notable pickup from the upwardly-revised 0.1% increase seen in December and raised the likelihood, in the market’s view, that the Fed will have to hold rates higher for longer to bring inflation back toward their 2% average target.
• The PPI was even hotter than CPI, rising the most since June at 0.7% in January, a stark contrast from the 0.2% decrease reported in December.
  • Yearly, PPI, like CPI, continues to trend notably lower than its 2022 summer peak but remains significantly elevated in a historical context and above where Federal Reserve officials are comfortable.
• Short- and long-term rates rose moderately on the back of both reports.
  • The 2-year Treasury yield ended the week ten basis points higher at 4.60%, while the 10-year Treasury yield rose a slightly more modest 8bps to finish the week at 3.82%.

The look forward

Upcoming economic data releases

• S&P Global Manufacturing / Services PMI – Tuesday
• Existing Home Sales – Tuesday
• FOMC Meeting Minutes - Wednesday
• MBA Mortgage Applications – Wednesday
• Chicago Fed National Activity Index – Thursday
• Fourth quarter GDP (second estimate) – Thursday
• Core PCE – Thursday
• Jobless Claims – Thursday
• New Home Sales – Friday
• University of Michigan Consumer Sentiment Index – Friday

Upcoming Federal Reserve Speakers

• Williams – Wednesday
• Bostic, Daly – Thursday
• Jefferson, Mester, Bullard, Collins, Waller – Friday

Rates snapshot

Market implied policy path (overnight indexed swap rates)