Q4 GDP slows, funding pressures intensify

Interest rates

• Bucking the trend seen since the turn of the year, Treasury yields broke higher across a slightly flatter curve.
  • Treasury yields advanced in a tight range last week, with the two and 10-year Treasury yields each moving five basis points higher to end the week at 4.19% and 3.52%, respectively.
  • The curve remains significantly inverted, and the 2s/10s basis continues to hover near several decade lows at -0.70%.
  • Although the 2s/10s basis is off the historic lows set in December and has been inverted for over six months, the measure remains well below the one-year average of -0.16%.
• In a quiet week for Fed speakers in the leadup to the January 31-February 1 FOMC monetary policy meeting, market participants’ expectations for policy changes are mostly unchanged from the week prior.
  • Current estimates suggest the FOMC will raise the Target Range by 25 basis points at Wednesday’s FOMC meeting and again by 25 basis points at the March monetary policy meeting.
  • Investors are split on a third 25 basis point hike, with current market pricing suggesting a 30% chance of a third 25 basis point hike at the May meeting.
  • Finally, market consensus points to several 25 basis point reductions to end 2023 and begin 2024.
• Despite the modest rise in real rates across the curve last week, real yields turned lower as inflation expectations picked up on the back of a smaller-than-expected drop in the GDP Price Index released on Thursday.
  • Real yields at the five and 10-year points dropped four and six basis points to 1.29% and 1.19%, respectively.

Trading commentary

• Hedging activity has increased notably in the second half of January.
• Many clients have expressed a need for wholesale funding and have opted to lock in or cap the cost of the borrowings with interest rate swaps and caps.
  • Specifically, pay-fixed swaps have been the predominant interest rate derivative utilized in the current environment as clients pair the swap with a short-term FHLB Advance to extend the borrowing’s duration synthetically, often at a materially cheaper rate than can be obtained for the same term in the wholesale markets.
  • While hedging borrowings has grown in popularity since the turn of the year, we continue to see clients achieve a similar economic objective, mitigating liability sensitivity and protecting against further increases in interest rates, by utilizing the asset side of the balance sheet in a Portfolio Layer Method fair value hedging relationship.
• Finally, programmatic hedging for a declining interest rate environment continued last week, although many clients have opted to use interest rate swaps rather than options in recent weeks.

Funding pressures intensify

• With the fourth-quarter earnings season in full swing, U.S. financial institutions are offering their 2023 outlooks, and many have suggested that deposit pressures will continue into 2023.
• According to an analysis conducted by S&P Global Market Intelligence, price pressures accelerated significantly in the fourth quarter relative to the third quarter.
  • Looking at the results in the report, the industry average rate paid on one-year certificates of deposit rose just over 100 basis points in 2022 to 1.31%.
  • Factoring in the FOMC’s rate hikes over the same one-year period, the industry average beta stands at approximately 30% and is expected to pick up in 2023, according to many analysts.
• The comments from industry executives and analysis conducted by S&P Global align with the hedging activity we have seen in the second half of 2022, and the start of 2023 as clients continue expressing a need for wholesale funding amid deposit outflows.

Economic data

• Market participants were the beneficiaries of several high-profile economic data releases last week.
• S&P Global’s Manufacturing and Services PMIs each topped the consensus estimate and the prior month’s readings but remain in contraction territory.
  • Although many investors saw the monthly pickup as a welcomed development, the services PMI reading notched its seventh consecutive contractionary reading, and the manufacturing release suggested that price pressures firmed month-over-month.
• The Fed’s preferred measure of inflation, core PCE, was released on Friday and indicated that core prices advanced 0.3% in December, in line with the consensus estimate but quicker than the 0.2% pace seen in November.
  • Services prices drove the monthly increase as goods prices continued to advance but at a slower pace than in 2022.
• Lastly, according to a Commerce Department release on Thursday, the U.S. economy accelerated at a 2.9% annualized pace in the fourth quarter.
  • The fourth quarter figure marked a notable slowdown from the 3.2% pace in the third quarter and highlighted a weakness in consumer demand.
  • Looking ahead, the Atlanta Fed’s GDPNow tool, which attempts to forecast the current quarter’s GDP in real-time, projects the economy to advance at a 0.7% annualized pace in the first quarter, a notable shift in pace from the second half of 2022.

The look forward

Upcoming economic data releases

• Dallas Fed Manufacturing Activity Index – Monday
• MNI Chicago PMI – Tuesday
• Conference Board Consumer Confidence Index – Tuesday
• MBA Mortgage Applications – Wednesday
• ADP Employment Report – Wednesday
• S&P Global US Manufacturing PMI – Wednesday
• ISM Manufacturing Index – Wednesday
• Jobless Claims – Thursday
• Factory Orders – Thursday
• Durable Goods Orders – Thursday
• January Non-Farm Payroll Report – Friday
• ISM Services Index – Friday

Upcoming Federal Reserve Speakers

• Fed Chair Powell Press Conference – Wednesday

Rates snapshot

Market implied policy path (overnight indexed swap rates)