Powell sends rates higher after Jackson Hole address
Balance Sheet Risk Management
Financial Institutions | Kennett Square, PA
Building on the momentum from a week earlier, Treasury yields moved higher across a flatter curve last week, while the major U.S. equity indices declined, as market participants turned all attention to Federal Reserve Chair Jerome Powell’s speech on Friday at the annual Jackson Hole Economic Symposium.
- Treasury yields trended higher over the week as market participants anticipated a hawkish speech from Fed Chair Powell.
- The two-year Treasury yield climbed 12 basis points to 3.37% and the 10-year rose a more modest six basis points to 3.04%, resulting in a flatter curve week-over-week.
- During his speech on Friday, Chair Powell reiterated that the Federal Reserve’s “overarching focus” is on combatting inflation and restoring price stability signaling that such an endeavor “will likely require maintaining a restrictive policy stance for some time.”
- Powell lived up to investors’ hawkish expectations suggesting that the Fed would be comfortable with an economic downturn resulting from monetary policy action saying that in order to restore price stability it will require the FOMC to use “our tools forcefully to bring demand and supply into better balance.”
- Looking at Fed Funds futures market pricing after Powell’s speech, market expectations for Fed action remain mostly unchanged with slightly better odds of a 75 basis point hike versus a 50 basis point hike at the next FOMC meeting in September and 1.25% of rate hikes expected from current levels by the year’s end.
- Real rates also turned higher last week with both the five-year and 10-year real yields climbing to multi-year highs at 0.47%.
- Despite the hawkish tone from the Federal Reserve last week, mid-term inflation expectations ticked higher by 5 basis points to 2.79%, while the Fed-preferred five-year forward, five-year breakeven inflation rate remained unchanged at 2.35%.
- Hedging activity continues to remain elevated on our balance sheet risk management desk, although activity slowed mid-week somewhat as clients paused to hear from Powell at Jackson Hole before picking up again on Friday afternoon.
- As noted previously, we continue to see the majority of hedging activity positioning for a downturn in rates.
- While we have seen a notable rise in the use of option-based products, particularly zero-cost collars, plain vanilla interest rate swaps are the most oft-used derivative product when implementing a down-rate hedging strategy.
- In the other direction, funding hedges have risen in popularity significantly in the last two months as clients begin to see deposits run off and look for replacements in the wholesale market.
- To date, we have seen a healthy mix of swap and cap strategies implemented to lock in or cap the cost of new wholesale funding.
- Depending on the specific FHLB and tenor of the derivative, swaps can optimize wholesale funding costs and often outperform the fixed rate alternatives offered at the FHLBs by 20-40 basis points.
Deposit pricing battles begin
- After deposit betas remained low across the banking industry in the wake of several quick and large increases to the Federal Funds Target Range to start the year, pricing battles have heated in recent weeks as excess liquidity slowly drains from the banking system and deposit run-off materializes.
- While still modest, the 1.7% sequential decline in total deposits at U.S. financial institutions in the second quarter marks the first quarterly contraction since 2019, according to S&P Capital IQ.
- Looking at funding pricing in aggregate, the cost of funds at U.S. financial institutions has increased 9 basis points sequentially to 0.24%.
- With market participants expecting another 1.25% of rate hikes by the year’s end, pricing pressures are expected to continue to firm as we approach 2023.
- Although all eyes were on Jackson Hole last week, market participants received several high-profile economic updates.
- Manufacturing activity appears to be slowing.
- Except for the upbeat Chicago Fed National Activity Index July reading, all the manufacturing data released last week pointed to a slowdown in manufacturing activity.
- Notably, the S&P Global U.S. Manufacturing PMI declined for the third consecutive month on depressed output and employment levels notching its worst reading since July 2020.
- Housing sector strength is beginning to fade.
- After seeing declines in mortgage applications, existing home sales, and building permits the week prior, July’s new home sales fell below both the June reading and the consensus expectation, contracting 12.6% month-over-month.
- Second quarter GDP still negative but revised higher.
- According to the Commerce Department, U.S. GDP contracted 0.6% in the second quarter, better than the -0.9% initial reading and the -0.7% consensus expectation.
- Looking ahead, the Atlanta Fed’s GDPNow tool, which attempts to forecast the current quarter’s GDP in real-time, forecasts the U.S. economy to expand at a 1.6% annualized pace in the third quarter.
The look forward
Upcoming economic data releases
- Dallas Fed Manufacturing Activity - Monday
- Conference Board Consumer Confidence Index - Tuesday
- ADP Employment Change - Wednesday
- Jobless Claims - Thursday
- S&P Global U.S. Manufacturing PMI - Thursday
- ISM Manufacturing Index - Thursday
- August Non-Farm Payroll Report - Friday
- Factory Orders - Friday
- Durable Goods Orders - Friday
Upcoming Federal Reserve speakers
- Brainard - Monday
- Barkin, Williams - Tuesday
- Mester, Bostic - Wednesday
- Bostic - Thursday
Market implied policy path (Overnight indexed swap rates)
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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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