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Market Update

Q1 GDP contracts, Treasury curve flattens

Date:
May 2, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

Market turbulence continued last week with the Treasury curve flattening and the major U.S. equity indices notching the fourth consecutive week of declines as growth fears reignited on the back of weak first-quarter earnings for some of the largest U.S. corporations and a negative first-quarter GDP print.

Interest rates

  • Although Treasury yields ended the week largely unchanged, volatility remained elevated as Treasury yields traded in a 15-20 basis point range over the week.
    • Looking at the shape of the Treasury curve, it stands slightly flatter than where it started the week, with the 2s/10s basis narrowing to 21 basis points, well flatter than the yearly average of 90 basis points.
  • As we have noted previously, real yields have been steadily climbing since the turn of the year on the back of expectations for an aggressive Fed hiking cycle.
    • On Friday, the 10-year yield again crossed into positive territory to 0.01%, its highest level since the onset of the pandemic.
  • While tenors shorter than 10 years are yet to turn positive, this year’s run-up in rates has closed the gap significantly with the five-year real yield increasing 120 basis points since the turn of the year to -0.38%.
  • Investors are gearing up for one of the most highly anticipated FOMC meetings in recent memory this week and are largely expecting the FOMC to raise the target range by 50 basis points on Wednesday, the first 50 basis point increase since May 2000.
    • Looking at Fed Funds futures pricing on Friday, market participants are fully pricing in 50 basis point hikes at the next three FOMC meetings with trading this week suggesting a roughly 50% chance of a 75 basis points hike at the June meeting.

                Trading commentary

                • Activity has remained elevated on our balance sheet hedging desk as clients look to derivative strategies that either protect against a continued rise in interest rates or that smooth earnings in the expected rising rate environment.
                  • Specifically, we have seen increased activity this quarter in hedging expected wholesale funding with pay-fixed swaps and caps.
                • On the structuring side, many of the strategies executed employed the use of forward-starting swaps with the effective period of the derivative beginning six-18 months from now to align with the institution’s expected wholesale borrowing needs.
                • On the other hand, we have seen significant down-rate hedging activity since the turn of the year as our asset-sensitive clients look to mitigate their sensitivities by executing receive-fixed swaps and pulling income forward to smooth earnings.
                  • To that end, a five-year receive-fixed Fed Funds swap offered just under 200 basis points of initial compensation on Friday.
                • Our back-to-back hedging desk saw significant activity last week as clients rushed to get deals in before the end of the month.
                  • Notably, we have noticed an uptick in activity from clients proactively amending existing LIBOR-based contracts to Term SOFR.

                              U.S. Financial Institutions see lower earnings in Q1, but remain positive on outlook

                              • Many U.S. financial institutions have reported first-quarter earnings in the last few weeks with a mixed bag of results.
                                • According to S&P Capital IQ, four of the six financial institutions with assets between $50-$100 billion reported lower EPS quarter over quarter as interest rates moved notably higher and geopolitical uncertainty increased dramatically.
                              • Looking at financial institutions with assets ranging from $10-$50 billion, the story is largely similar with 22 of the 36 institutions that have reported thus far reporting declines in EPS, while 17 institutions saw both quarterly and yearly EPS declines.
                              • While earnings have seen pressure in the last quarter, many institutions expressed an optimistic outlook for the future pointing to the expected pickup in net interest margin from the rise in interest rates and the return of loan growth that has continued into the first quarter.

                                                          Economic data

                                                          • While the week’s economic calendar was packed with several high-profile pieces of economic data, the Q1 GDP figure and the update to the Fed-preferred measure of inflation garnered the lion’s share of attention from market participants and the financial media alike.
                                                          • Heads turned on Thursday when the advance Q1 GDP release indicated that the U.S. economy contracted at a 1.4% annualized pace last quarter, the first contraction since 2020 and below nearly all economists’ forecasts before the release.
                                                            • The contraction follows the robust 6.9% pace seen in the fourth quarter and was driven primarily by a surge in imports coupled with a decline in inventory investment from corporations and a decline in fiscal spending from the federal government.
                                                          • While the Q1 GDP print was negative, many analysts highlighted that the consumer appears to remain strong, with real final sales increasing at a 2.6% annualized pace.
                                                          • Looking ahead, the Atlanta Fed’s GDPNow model, which attempts to forecast the current quarter’s GDP in real-time, forecasts the U.S. economy to expand at a modest 1.9% annualized pace in the second quarter.
                                                          • Thursday also marked the release of the Fed-preferred measure of inflation, core PCE.
                                                            • According to the release, the core PCE measure, which excludes the food and energy components, rose less than the consensus estimate to 5.2%, a moderate pickup from the 5% increase seen last quarter, but lower than the 6.1% recent high from June 2021.
                                                          • Finally, consumer confidence appears to be holding up as both the Conference Board Consumer Confidence Index and the University of Michigan Consumer Sentiment Index reported roughly unchanged readings from the prior month.

                                                          The look forward

                                                          Upcoming economic data releases

                                                          • S&P Global U.S. Manufacturing PMI - Monday
                                                          • ISM Manufacturing Index - Monday
                                                          • Factory Orders - Tuesday
                                                          • Durable Goods Orders - Tuesday
                                                          • FOMC Monetary Policy Meeting - Tuesday/Wednesday
                                                          • ADP Employment Report - Wednesday
                                                          • Jobless Claims - Thursday
                                                          • April Non-Farm Payroll Report - Friday

                                                                                          Upcoming Federal Reserve Speakers

                                                                                          • Powell Post-FOMC Press Conference - Wednesday
                                                                                          • Williams, Bostic, Bullard, and Daly - Friday

                                                                                                                          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

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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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