Powell’s hawkish comments spark Treasury sell-off

Interest rates

• Treasury yields rose notably across the curve, resulting in a slightly steeper curve week over week.
  • The 2-year Treasury yield moved 20 basis points higher, while the 10-year yield moved 21 basis points higher to end the week at 4.50% and 3.74%, respectively.
  • Despite steepening week-over-week, the Treasury curve remains inverted near the multi-decade lows set in December and well below the 2s/10s basis yearly average of -0.21%.
• The expectation-smashing January non-farm payroll report set the tone for last week’s sell-off, and Fed Chair Powell’s hawkish comments at Tuesday’s Economic Club of Washington event only further sparked upward pressure on yields.
  • Specifically, Powell emphasized the “need to do further rate increases” especially in light of the “extraordinarily strong” labor market and highlighted that the policy rate’s peak might be higher than traders anticipate.
  • Looking at policymakers’ most recent rate forecasts, released in December, compared to current market pricing, there is a notable divergence of approximately 75 basis points between where Fed officials see the policy rate at the end of 2024 and where market participants forecast the rate to be.
• While market participants continue to expect 25 basis point hikes at the next two FOMC meetings in March and May, expectations for rate cuts at the end of 2023 and the beginning of 2024 pulled back last week, with current market pricing suggesting the policy rate will be approximately 25 basis points higher than current levels in January 2024, nearly 50 basis points higher than the market’s expectation one week ago.

Trading commentary

• Hedging activity has remained robust as we enter the middle of February.
• As noted previously, we have seen a significant balancing in the level of activity between clients mitigating asset sensitivity and preparing for falling rates, and others locking in wholesale borrowing costs and preparing for rising rates.
  • For clients looking to lock in the cost of term wholesale funding, we have seen many pair a short-term FHLB advance with a pay-fixed swap to extend the duration of the wholesale borrowings at cheaper levels than can be obtained in the brokered market and at the FHLB.
• Regarding falling rate hedges, we have seen an increase in the use of option-based products, specifically interest rate floors, as asset-sensitive institutions look for insurance against a drop in net interest margin in a declining rate environment.
  • Notably, most clients have stayed short in the two to five-year maturity range when purchasing options, attempting to strike the balance between the length and cost of the option.

U.S. banks take down wholesale funding

• Consistent with the significant increase in wholesale borrowing hedging activity that we have reported, U.S. banks are increasingly turning to the wholesale markets to strengthen their funding positions amidst industry-wide deposit outflows.
• With fourth-quarter earnings season coming to a close, a look back at commentary and financials from U.S. banks shows improving yearly NIM, but a sense of caution from many institutions who have seen interest expense increase significantly amid elevated competition for deposits and higher interest rates.

Economic data

• In a very light week for economic data, market participants received updates on consumer sentiment and the labor market.
• According to the University of Michigan, consumer sentiment improved modestly in February, notching its highest level since April 2022.
  • Notably, one-year inflation expectations picked up 0.3% month-over-month to 4.2%, but long-term expectations remained anchored at 2.9%.
• Jobless claims ticked slightly above the consensus expectation and last week’s level to 196,000.
  • Although the most recent reading snapped a month-long streak of weekly declines, last week’s 196,000 level sits modestly below the one-year average of 213,000 claims.

The look forward

Upcoming economic data releases

• Consumer Price Index – Tuesday
• MBA Mortgage Applications – Wednesday
• Empire Manufacturing Index – Wednesday
• Retail Sales – Wednesday
• Industrial Production – Wednesday
• Housing Starts – Thursday
• Building Permits – Thursday
• Jobless Claims – Thursday
• Philadelphia Fed Business Outlook Survey – Thursday
• Producer Price Index – Thursday
• Leading Index – Friday

Upcoming Federal Reserve speakers

• Bowman – Monday
• Barkin, Logan, Harker, Williams – Tuesday
• Mester, Bullard, Cook – Thursday
• Barkin, Bowman – Friday

Rates snapshot

Market implied policy path (overnight indexed swap rates)