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Market Update

Labor market shows strength; hedging activity increases

Date:
June 6, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

In a week packed with high-profile economic updates and a robust Federal Reserve speaking calendar, Treasury yields across the curve moved notably higher, erasing the moves from the week prior. The major U.S. equity indices resumed their decline after seeing the first positive week in nearly two months the week prior.

Interest rates

  • Treasury yields across the curve moved over 20 basis points last week, marginally steepening the curve, as an upside surprise to inflation in the Eurozone, a more hawkish than expected Bank of Canada, and largely positive U.S. economic data saw investors reprice expectations for interest rates in the short- and long-term higher.
    • The 2s/10s basis remained roughly unchanged by the week’s end despite the sharp rise in rates last week, holding the steepening moves from the week prior, as the two-year finished the week 20 basis points higher at 2.66%, while the 10-year finished the week roughly 22 basis points higher at 2.96.
  • Much of the rise in the short end of the curve was due to a shift in expectations around interest rate hike probabilities in 2022.
    • Specifically, expectations for a 50 basis point hike in September increased substantially, with investors now placing a roughly 75% chance of that outcome compared to the approximately 30% chance given to a 50 basis point hike in September the week prior.
    • Looking forward to the year’s end, investors now see the Federal Funds Target Range 2% higher from current levels in December compared to the 1.75% expectation implied the week prior.
  • Last week’s rise in rates saw real yields gain back much of the ground lost during the previous week.
    • The 10-year real yield now sits at 0.22%, 11 basis points higher than last week, while the seven-year real yield crossed back into positive territory and stands at 0.07%.

                          Trading commentary

                          • As we enter the summer months, we saw a flurry of activity across our balance sheet desk last week with clients implementing a variety of different hedging strategies in the face of historically elevated volatility and a largely uncertain path for interest rates.
                          • Looking at the strategies preparing for a downturn in rates, we saw a host of receive-fixed swaps executions last week as clients look to extend the duration of the loan portfolio and pull income forward.
                            • Interestingly, we have seen a significant pickup in option-based strategies, particularly interest rate collars, as this structure allows clients a more targeted way to set their level of interest rate risk protection and to enjoy the benefit of their asset sensitivity while the index rate remains within the collar bands.
                            • Directionally similar, we saw several clients unwind existing pay-fixed swaps that were executed in the lower-rate environments of 2020 - 2021 and were designed to protect the balance sheet from AOCI / TBV degradation in a rising rate environment.
                          • Separately, we continue to see clients take advantage of the flexibility afforded by the recent upgrade to the fair value hedging model in the form of the Portfolio Layer Method, using the investment portfolio or fixed-rate loan portfolio as the hedge vehicle, to protect the balance sheet from a rise in interest rates above what is currently priced in by the market.
                            • Similarly, we saw some clients hedge the purchase of newly issued, longer-duration securities using forward-starting pay-fixed swaps to allow the institution to enjoy the yields associated with the now higher rate environment without any cash flow impact from the swap in the near term, while mitigating the interest rate risk on the later years of the security.
                          • Our back-to-back hedging desk saw an expected increase in activity last week in the lead-up to and immediate aftermath of May month-end as borrowers appear eager to lock-in long term fixed-rate financing given the uncertain inflation outlook.
                            • As we head toward the halfway point of 2022, we have seen sustained activity of borrowers re-indexing LIBOR-based loans and swaps to LIBOR alternatives, primarily CME Term SOFR.

                                                  Big bank executives signal caution

                                                  • Executives at JPMorgan and Wells Fargo warned that Federal Reserve tightening could slow loan growth and the broader economy in the coming months.
                                                    • Speaking at an investor conference on Wednesday, Wells Fargo CEO Charles Scharf highlighted the recent pickup in loan growth and commented that consumers are “still extremely strong,” but noted that “the economy has to slow” and that he expects loan growth “to moderate a little bit, albeit still continue to have growth as the quarters move on.”
                                                  • JPMorgan Chair and CEO Jamie Dimon painted a darker picture of the economic outlook prophesying that a “hurricane” is coming.
                                                    • Dimon commented the Federal Reserve’s balance sheet runoff initiative will result in “a huge change in the flow of funds around the world,” and added that the war in Ukraine introduces another headwind for the global economy.

                                                                                        Economic data

                                                                                        • Last week investors received a plethora of high-profile economic data releases that largely pointed to a strengthening U.S. economy.
                                                                                        • After seeing notable declines in the regional manufacturing surveys in recent weeks, the national ISM Manufacturing Index defied calls for a decline and instead rose moderately above the prior month’s reading as the new orders measure saw a sizeable pickup.
                                                                                          • While the jump in new orders and overall pickup in the index level was encouraging, some analysts threw cold water on the report pointing to the still-elevated “prices paid” component that showed inflation continuing to run near the historical highs for the series.
                                                                                        • While investors had plenty to take in last week, nothing grabbed the attention of market participants quite like the May non-farm payroll report.
                                                                                          • According to the Labor Department, the U.S. economy added 390,000 jobs in May, moderately below the levels seen in April but far above the consensus estimate calling for approximately 318,000 jobs.
                                                                                          • With the latest increases, payrolls sit just under one million jobs below pre-pandemic levels.
                                                                                          • Friday’s release was a welcomed surprise and a positive sign for the recovering but seemingly robust labor market after Wednesday’s release of the ADP employment report showed a more-muted 128,000 private payroll additions in May, far below most analysts’ estimates.
                                                                                          • Finally, the unemployment rate held steady at 3.6% and the labor force participation rate crept marginally higher.

                                                                                                  The look forward

                                                                                                  Upcoming economic data releases

                                                                                                  • Wholesale Inventories - Wednesday
                                                                                                  • Jobless Claims - Thursday
                                                                                                  • Consumer Price Index - Friday
                                                                                                  • University of Michigan Consumer Sentiment - Friday

                                                                                                                                            Upcoming Federal Reserve speakers

                                                                                                                                            • There will be no Federal Reserve speakers this week as they enter the blackout period prior to the June 14 - 15 FOMC monetary policy meeting.

                                                                                                                                                                                    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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