Rates drop amid weak economic data

Rates drop amid weak economic data

• Treasury yields dropped across the curve, most prominently at the short-end, as economic reports related to consumer confidence, employment, GDP, and manufacturing all dipped below analyst estimates.

Portfolio Layer Method hedging activity increases

• After seeing a significant pickup in asset-sensitive hedging activity the week prior, liability-sensitive strategies that aim to protect the balance sheet against a rising interest rate environment returned in earnest last week.

Deposit costs drag bank margins lower

• After experiencing notable deposit outflows in the first quarter of the year, U.S. banks faced slower but continued deposit outflows in the second quarter.

Q2 GDP disappoints, employment reports mixed, consumer confidence declines

• Before the Labor Day holiday, market participants received a deluge of economic updates, most of which suggested a slowing U.S. economy.

Rates drop amid weak economic data

• Treasury yields dropped across the curve, most prominently at the short-end, as economic reports related to consumer confidence, employment, GDP, and manufacturing all dipped below analyst estimates.
• The 2-year Treasury yield fell a robust 16 basis points to 4.87%, while the 10-year yield declined a more modest five basis points to end the week at 4.18%.
• The more pronounced moves at the short-end steepened the curve and sent the 2s/10s basis back toward its yearly average, nearly erasing the prior week's flattening.
• A handful of Fed officials held speaking engagements during the week, offering their latest thoughts on the monetary policy outlook following Fed Chair Powell's hawkish commentary at Jackson Hole the week prior.
• Atlanta Fed President Raphael Bostic delivered a relatively dovish message stating that he believes the current policy level is "appropriately restrictive" and arguing that the FOMC should be "cautious and patient" in upcoming meetings to avoid "inflicting unnecessary economic pain."
• Expectations for another hike this year decreased significantly last week in the wake of Bostic's commentary and the raft of underwhelming economic reports.
• Looking at Fed Funds futures pricing at the close on Friday, investors now only see a 35% probability of another hike this year, compared to over 60% the week prior, and anticipate the FOMC to begin cutting rates in Q2 2024.

Portfolio Layer Method hedging activity increases

• After seeing a significant pickup in asset-sensitive hedging activity the week prior, liability-sensitive strategies that aim to protect the balance sheet against a rising interest rate environment returned in earnest last week.
• Although wholesale borrowing hedging activity has experienced notable activity levels this year, Portfolio Layer Method hedging represented most of the strategy implementations during the last week of the month.
• Loan pools, composed primarily of fixed-rate residential and commercial real estate loans, served as support for the hedge accounting relationship in most of these transactions, but we also continue to see clients utilize AFS securities in order to experience a direct geographic offset to the valuation movements in the bond portfolio.
• On the customer hedging side, borrowers continue to purchase interest rate caps - typically from one to three years in length - that are in-the-money to provide immediate interest savings and known interest costs while also avoiding swap breakage should rates fall substantially in the near term.
• Borrowers have shown a willingness to pay the out-of-pocket costs associated with these caps to gain greater flexibility to refinance in the future.

Deposit costs drag bank margins lower

• After experiencing notable deposit outflows in the first quarter of the year, U.S. banks faced slower but continued deposit outflows in the second quarter.
• According to an analysis conducted by S&P Capital IQ, the median taxable equivalent net interest margin declined five basis points to 3.40% in the second quarter.
• The margin pressure comes as banks grapple with substantial deposit competition amid a historic Fed tightening campaign and the highest rates in recent memory.
• According to the analysis, the industry’s average cost of deposits rose 37 basis points sequentially, equating to a roughly 80% beta with fed funds movements in the same period.
• Deposit outflows have contributed to an increased reliance on wholesale funding across the banking space this year and many of our clients have hedged new wholesale borrowings with pay-fixed interest rate swaps to fix the cost of the new funding synthetically, typically at cheaper levels than available with traditional fixed-rate term alternatives.

Q2 GDP disappoints, employment reports mixed, consumer confidence declines

• Before the Labor Day holiday, market participants received a deluge of economic updates, most of which suggested a slowing U.S. economy.
• According to the Commerce Department’s second estimate of Q2 GDP, the U.S. economy expanded at a 2.1% annualized pace last quarter, notably lower than the 2.4% initial estimate.
• Digging into the components of the report, consumer spending expanded at a moderately greater pace than initially reported, but lower business investment outweighed those gains and drove the aggregate figure lower.
• Looking ahead, the Atlanta Fed’s GDPNow tool, which attempts to estimate the current quarter’s GDP in real-time, currently forecasts GDP growth to more than double to a 5.6% annualized pace in the third quarter.
• The highly anticipated August non-farm payroll report and the ADP employment report painted a mixed picture of the labor market.
• According to the Commerce Department, the U.S. economy added 187,000 jobs, moderately higher than the consensus estimate and in line with July’s initial estimate.
• Notably, the prior two months’ job gains were revised lower by over 100,000 jobs, dampening investor sentiment following the August report’s beat.
• The unemployment report also unexpectedly increased to 3.8% due to a noticeable rise in labor force participation in August.
• On the other hand, the ADP private payroll report underwhelmed, falling well below the consensus estimate and reporting less than half of the job gains seen one month ago.
• Continuing with recent trends, the latest Conference Board Consumer Confidence report and several high-profile manufacturing releases, including the ISM Manufacturing Index and the S&P Global U.S. Manufacturing PMI, exhibited weakness and reported worsening conditions.

The look forward

Upcoming economic data releases

• Factory Orders – Tuesday
• Durable Goods Orders – Tuesday
• MBA Mortgage Applications – Wednesday
• Trade Balance – Wednesday
• S&P Global U.S. Services / Composite PMIs – Wednesday
• ISM Services Index – Wednesday
• Jobless Claims – Thursday
• Wholesale Inventories – Friday

Upcoming Federal Reserve Speakers

• Collins, Logan – Wednesday
• Harker, Goolsbee, Williams, Bostic, Bowman, Logan – Thursday
• Barr – Friday

Rates snapshot

Market implied policy path (overnight indexed swap rates)