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Market Update

July NFP tops expectations, Treasury yields advance

Date:
August 8, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

After falling for three consecutive weeks, Treasury yields moved notably higher last week while the major U.S. equity indices ended the week mixed as investors digested hawkish comments from Federal Reserve officials, a robust July jobs report, and a packed second-quarter corporate earnings calendar.

Interest rates

  • Interest rate volatility continued in earnest last week with Treasury yields across the curve moving over 20 basis points higher.
    • The short-end of the curve saw the largest moves with the two and three-year Treasury yields each rising approximately 35 basis points after a strong jobs report and hawkish comments from Fed officials forced market participants to reevaluate their expectations for Fed action in the near term.
      • San Francisco Fed President Mary Daly sparked the week-long selloff on Tuesday morning when she commented that the Fed is “nowhere near” done fighting inflationary pressures that are “far too high", a sentiment echoed by several Fed officials during the week including Fed hawk James Bullard who indicated a preference for “front loading” rate hikes.
    • Looking at Fed Funds futures pricing as of Friday’s close, market participants now see a 75% chance of a 75 basis point hike at the next FOMC monetary policy meeting, up from a 25% chance the week prior.
    • The steep rise in the front-end of the curve saw the Treasury curve flatten significantly during the week, pushing the 2s/10s basis further into negative territory at -0.40%, the largest inversion since the fall of 2000.
  • The rise in rates across the curve coupled with inflation expectations turning lower sent real yields markedly higher last week.
    • The five-year real yield turned positive, rising 33 basis points on the week while the 10-year real yield regained much of the ground lost the week prior, rising approximately 23 basis points over the week to 0.37%.

    Trading commentary

    • Elevated interest rate volatility translated into elevated hedging activity crossing our balance sheet risk management desk last week.
    • Several clients capitalized on the steep rise in short and mid-term rates, implementing downrate hedging strategies designed to protect margin from a downturn in interest rates.
      • To date, most clients have leveraged one-month LIBOR and Prime floating rate asset portfolios to achieve financial-statement-friendly hedge accounting treatment, using either plain-vanilla receive-fixed swaps or zero-cost collars to accomplish the economic objective.
    • Nonetheless, we continue to see our liability-sensitive clients protect against a rise in interest rates and lock in the cost of wholesale funding and deposits.
      • While pay-fixed swaps designed to lock in the cost of wholesale funding have been the most popular uprate hedging strategy implemented this year, last week we saw others look to their indexed deposit portfolios and buy out-of-the-money caps to provide insurance against rates moving sharply higher.

      OCI degradation continues in the second quarter

      • As expected, the steep rise in interest rates in the second quarter caused further declines in the OCI marks on most financial institutions' balance sheets as the market value of AFS investment portfolios continued to fall.
      • According to S&P Capital IQ, the 15 largest U.S. financial institutions saw nearly $29 billion in additional market value losses in the second quarter, well above levels seen in recent history other than the $54 billion loss seen in the first quarter of this year.
        • OCI degradation has eased somewhat in recent weeks as Treasury yields across the curve have declined in aggregate, but last week’s substantial rise higher erased a significant portion of those gains and added to the pain many U.S. financial institutions have been feeling since the turn of the year.

        Economic data

        • Several high-profile pieces of economic data were released last week.
        • Monday brought a comprehensive update to the manufacturing industry with both the national ISM Manufacturing Index and the S&P Global U.S. Manufacturing PMI posting levels near last month’s readings and the consensus expectation.
          • Digging into the reports, both releases notched the lowest readings since the summer of 2020 as both new orders and production turned lower.
          • Notably, the ISM prices paid component showed signs of easing inflationary pressures after the index fell to its lowest level since August 2020.
        • Although market participants were the beneficiaries of a plethora of high-profile updates, nothing garnered more attention from investors than Friday’s release of the July non-farm payroll report.
          • According to the U.S. Labor Department, the U.S. economy added 528,000 jobs in July, over twice Wall Street estimates and far outpacing the upwardly revised 398,000 jobs added in June.
          • The strong report added credence to the hawkish comments offered by the Fed’s Daly and Bullard earlier in the week and sent the 2-year Treasury yield 21 basis points higher on Friday.
          • While the ISM prices paid index suggested easing inflationary pressures earlier in the week, a strong July average hourly earnings reading coupled with an upward revision to the June reading caused some analysts to speculate that inflation is becoming further entrenched in the economy.

          The look forward

          Upcoming economic data releases

            • MBA Mortgage Applications - Wednesday
            • Consumer Price Index - Wednesday
            • Wholesale Inventories - Wednesday
            • Producer Price Index - Thursday
            • University of Michigan Consumer Sentiment Index - Friday

            Upcoming Federal Reserve Speakers

            • Evans, Kashkari - Wednesday
            • Daly - Thursday

              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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