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Market Update

Rates drop as Fed officials hint at smaller hikes

Date:
November 28, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

In a holiday-shortened week, Treasury yields declined while the major U.S. equity indices advanced after several Fed officials signaled plans to scale back the pace of interest rate hikes at future meetings.

Interest rates

  • Treasury yields pulled back across an ever-flattening curve.
    • The long end of the curve saw the most significant declines as the 10-year Treasury yield fell 14 basis points during the week to 3.68%.
    • The pronounced pullback in longer-term rates sent the 2s/10s basis, a popular measure of the Treasury curve’s shape, to its lowest level since 1981 at -0.78%.
  • A combination of Fed officials’ commentary and the release of the latest FOMC meeting minutes instilled a belief in market participants that the Fed will soon slow the pace of interest rate increases.
    • Cleveland Fed President Loretta Mester and San Francisco Fed President Mary Daly both emphasized that the Fed is far from finished with its fight against inflation and expects to continue raising rates into 2023.
    • Loretta Mester sent rates lower on Monday, however, after she commented she thinks the Fed “can slow down from the 75 at the next meeting.”
    • Support for slowing the pace of interest rate increases also seems to be growing more broadly at the Fed after the latest FOMC meeting minutes indicated that “a number of participants” believed that it would soon “become appropriate to slow the pace of increase” of the policy rate.
  • Finally, real yields experienced an even greater pullback last week due to increasing inflation expectations.
    • Both the 5-year and 10-year breakeven inflation measures moved higher last week.
    • Increased inflation expectations coupled with the decline in nominal rates sent the 5-year and 10-year real yields lower to 1.51% and 1.36%, respectively.

Trading commentary

  • Hedging activity continued across our balance sheet strategies desk at the start of the week but slowed in the back half as the Thanksgiving holiday in the U.S. took center stage.
  • As mentioned previously, approximately 70% of the hedging strategies we helped implement protect against a decline in interest rates.
    • Clients using these strategies are often asset-sensitive institutions leveraging their floating-rate commercial real estate portfolios to satisfy the hedge accounting objectives.
  • The notable rise in wholesale funding usage across the banking space has also translated into rising rate hedging activity crossing our desk as clients look to lock in or cap the cost of new wholesale borrowings.
    • Although wholesale funding hedging strategies vary, clients often couple pay-fixed interest rate swaps with short-term SOFR-based FHLB advances to accomplish their risk objectives.

Credit quality declines at Credit Unions in Q3

  • According to an analysis conducted by S&P Capital IQ, credit quality worsened in Q3 as rising interest rates and high inflation deteriorated the finances of credit union borrowers.
    • Net charge-offs (NCO) increased for the fourth consecutive quarter bringing the industry NCO ratio to 0.34%, a five basis point increase from the second quarter.
  • Although credit quality has worsened marginally in recent quarters, loan growth has continued in Q3 at credit unions.
    • Loans and leases increased 5.0% in the third quarter, with commercial loans and lines of credit driving the largest share of the increase.

Economic data

  • In a light week of economic data, market participants received updates on the manufacturing industry, the services sector, and consumer sentiment.
  • The manufacturing outlook continued to worsen after two regional manufacturing indices pointed to a decline in activity last week.
    • Interestingly, the significant improvement in new orders reported in the Richmond Fed Manufacturing report was more than offset by shipments and capacity utilization declines.
  • S&P Global’s Manufacturing and Services PMIs both unexpectedly reported substantial declines from the levels seen in October.
    • Supporting the trend in recent regional surveys, the manufacturing PMI reading fell into contractionary territory due to a drop in new orders marking the index’s worst reading since the pandemic.
    • The services sector reading also experienced a notable decline as service providers reported falling demand in the face of decades-high inflation and historically elevated interest rates.
  • Finally, according to the preliminary University of Michigan Consumer Sentiment Index reading, consumer sentiment unexpectedly improved in November.
    • Consumers appear concerned about the labor market as unemployment expectations hit their worst level since 2011.
    • Notably, 5 and 10-year inflation expectations held constant in the report, but inflation expectations for the next year ticked down commensurate with declining gasoline prices.

The look forward

  • Upcoming economic data releases
    • Dallas Fed Manufacturing Activity Index – Monday
    • Conference Board Consumer Confidence Index – Tuesday
    • ADP Employment Report – Wednesday
    • Q3 GDP (2nd estimate) – Wednesday
    • Wholesale Inventories – Wednesday
    • Core PCE – Wednesday
    • Beige Book – Wednesday
    • Personal Income / Spending – Thursday
    • Jobless Claims – Thursday
    • S&P Global US Manufacturing PMI – Thursday
    • Construction Spending – Thursday
    • ISM Manufacturing Index – Thursday
    • November Non-farm Payroll Report - Friday
  • Upcoming Federal Reserve Speakers
    • Williams, Bullard – Monday
    • Powell, Bowman, Cook – Wednesday
    • Logan, Bowman, Barr, Dobbeck – Thursday
    • Evans - Friday

Rates snapshot

Rates Snapshot 11 28 22

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

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.

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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