Rates climb amid inflation fears

Fed speak, inflation data reinforce “higher for longer” sentiment

• Last week’s rise continued the significant recalibration of Fed rate expectations that we have seen since the beginning of February as hotter-than-expected inflation data and hawkish Fed speak drove rates higher.

Portfolio Layer Method hedging increases amid upward rates pressure

• After seeing a significant return to falling rate hedging the week prior, our balance sheet strategies team helped implement several Portfolio Layer Method hedging strategies last week as liability-sensitive institutions looked to protect against continued increases in interest rates.

CRE delinquencies rise in Q4

• Despite a sharp drop in the third quarter, Commercial Real Estate (CRE) delinquency rates at U.S. financial institutions increased in the final quarter of the year.

Manufacturing and consumer confidence data disappoint

• Manufacturing and consumer confidence data released last week performed below analyst expectations and pointed to slowing growth and increased inflation fears.

Fed speak, inflation data reinforce “higher for longer” sentiment

• Treasury yields continued their month-long run-up last week, as the 2-year Treasury yield rose eight basis points to 4.86%, and the 10-year yield rose two basis points to 3.97%.
  • The moves further inverted the curve and pushed the 2s/10s basis to levels not seen in 40 years.
• Last week’s rise continued the significant recalibration of Fed rate expectations that we have seen since the beginning of February.
  • Expectations for the policy rate at the end of 2023 and the beginning of 2024 have changed drastically in recent weeks.
  • At the start of February, market participants forecasted the Fed Funds rate to sit at approximately 4.15% in January 2024, over 100 basis points lower than where current market expectations see the January 2024 Fed Funds rate.
• Much of the recent rise is attributed to hot inflation releases. Last week, market participants received two more inflation-related readings in the form of the ISM Manufacturing report’s “prices paid” measure and the Labor Department’s unit labor costs reading.
  • Both measures, especially the unit labor cost report, suggested that inflationary pressures remain much firmer than investors expected.
• Fed officials also reinforced the “higher for longer" sentiment during speaking engagements last week.
• Most of the commentary from officials expressed a view that the Fed would have to continue rate increases in the near term, especially if inflation and employment data continue to run hot, and hold rates at those higher levels long enough to allow for the policy rate changes to influence the broader economy and bring inflation back closer to their 2% average target.

Portfolio Layer Method hedging increases amid upward rates pressure

• After seeing a significant return to falling rate hedging the week prior, our balance sheet strategies team helped implement several Portfolio Layer Method hedging strategies last week as liability-sensitive institutions looked to protect against continued increases in interest rates.
• While we continue to see many clients express a need for wholesale funding and use that funding as support for the hedge accounting relationship when entering into rising rate hedging strategies, most strategy executions last week leveraged new improvements to the fair value hedging framework, the Portfolio Layer Method, pointing the derivative to fixed-rate assets rather than wholesale borrowings to support the hedging accounting relationship.
• On the customer hedging side, back-to-back programs continue to take advantage of loan modifications to proactively move loans from LIBOR to Term SOFR ahead of the July 1 transition.
  • Along the same lines, borrowers with existing swap assets that are approaching loan or swap maturity are looking to use their swap asset to “buy down” the rate on their new financing while also moving the debt to Term SOFR and assuaging fears that rates will continue to rise.

CRE delinquencies rise in Q4

• Despite a sharp drop in the third quarter, Commercial Real Estate (CRE) delinquency rates at U.S. financial institutions increased in the final quarter of the year.
  • According to an S&P Global Market Intelligence analysis, delinquencies have increased to 0.65% of outstanding CRE loans compared to 0.58% in the third quarter.
  • The uptick in delinquencies comes as many U.S. financial institutions have reported a broad-based tightening in lending standards in the last six months.
• Although delinquencies are on the rise quarterly, CRE delinquencies sit approximately six basis points below the levels reported in the fourth quarter of 2021.

Manufacturing, consumer confidence data disappoint

• In a busy week for economic data releases, investors received mixed signals on the state of the U.S. economy, although many indicators pointed to a slowing in activity.
• Manufacturing data released last week continued to disappoint.
  • The national ISM Manufacturing Index corroborated recent regional manufacturing activity data that suggested activity levels are contracting.
  • Although the new orders measure improved moderately over the last month, production decreased and the prices paid measure rose considerably monthly.
  • The Dallas Fed Manufacturing Index painted a similar picture, remaining in contractionary territory and reporting a significant pickup in prices and notable declines in productivity and new orders.
• After a brief period of improvement, consumer confidence is coming under pressure again, according to the Conference Board.
  • Tuesday’s February consumer confidence reading fell well short of the consensus estimate and January’s reading, notching the lowest level since November.
  • Although the “current conditions” piece of the report improved modestly, consumers’ six-month outlook declined to the lowest level since July on the back of increased concerns around inflation and layoffs.

The look forward

Upcoming economic data releases

• Factory Orders – Monday
• Durable Goods Orders – Monday
• Wholesale Inventories – Tuesday
• ADP Employment Report – Wednesday
• Trade Balance – Wednesday
• Jobless Claims – Thursday
• February non-farm payroll report – Friday

Upcoming Federal Reserve Speakers

• Powell – Tuesday
• Powell, Barkin – Wednesday
• Barr – Friday

Rates snapshot

Market implied policy path (overnight indexed swap rates)