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Market Update

Rates drop as inflation slows

Date:
November 14, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

In a volatile week of trading, Treasury yields moved sharply lower, while the major U.S. equity indices broke higher as market participants digested a lower-than-expected October inflation report and assessed its impact on the Federal Reserve’s tightening campaign.

Interest rates

  • Treasury yields declined substantially last week across a flatter curve.
    • Despite rising moderately to start the week, Treasuries rallied after Thursday’s Consumer Price Index (CPI) release showed inflation slowed in the last month.
    • The news of slowing inflation sent the 2-year Treasury yield to 4.34% by the week’s end, 32 basis points lower than where it started the week.
      • Although the front end of the curve experienced a steep pull-back, the 2s/10s basis inverted further to -0.52% as the 10-year Treasury yield fell an even greater 35 basis points during the week.
  • Slowing inflation prompted a recalibration of Federal Reserve hike expectations.
    • Expectations for a 75 basis point hike evaporated last week after several Fed officials suggested that slowing the pace of increases is desired and after Thursday’s CPI release clocked in lower than expected.
    • Market participants have fully priced in a 50 basis point hike and see virtually no possibility of a 75 basis point hike at the mid-December FOMC meeting, a notable change in pace should the Fed follow the market consensus.
    • Looking at expectations for 2023, market participants are pricing in 100 basis points of hikes from current levels by the end of the first quarter and expect the Fed to lower rates by 25 – 50 basis points in the final months of 2023.
  • The better-than-expected inflation reading sent inflation expectations notably lower.
    • The 5-year breakeven inflate rate fell 20 basis points last week to 2.47%, well off the recent high of 2.75% set in late October and closer to the Fed’s 2% target.
    • Despite the significant drop in breakeven inflation rates across tenors last week, real yields also saw notable declines as the 5-year and 10-year real yields dropped 24 and 26 basis points, respectively.

Trading commentary

  • Hedging activity remained elevated to start the week before slowing on Thursday in the wake of CPI-induced interest rate volatility.
  • While hedging strategies designed to protect against a falling interest rate environment remain the most popular, we saw a notable rise in wholesale funding hedges last week.
    • Specifically, several clients extended the duration of short-term FHLB borrowings with pay-fixed interest rate swaps, substantially mimicking the economics of a fixed-rate term advance but at cheaper levels.
    • Although several variations of the wholesale funding optimization strategy exist, recently, clients have opted to use SOFR-based floating-rate FHLB advances as the hedged item for these transactions, given the relative ease of matching the repricing characteristics of the borrowing to the repricing characteristics of the swap.

U.S. financial institutions return to wholesale markets

  • As we have mentioned in recent months, U.S. financial institutions have started tapping wholesale funding sources as deposit levels declined in aggregate across the banking industry.
  • According to an analysis conducted by S&P Global, third-quarter earnings calls increasingly mentioned current or expected use of wholesale funding, namely FHLB Advances and Brokered CDs.
    • Hedging activity crossing our balance sheet strategies desk supports these anecdotes as most of the rising rate protection strategies implemented this year across our client base have pointed the derivative to wholesale funding sources to achieve favorable hedge accounting treatment.
  • While the use of wholesale facilities has increased substantially as the year has progressed, some financial institutions have communicated that they have yet to see large deposit outflows to date or plan to use investment portfolio cash flows instead of wholesale borrowings to support loan growth in the coming quarters.

Economic data

  • In a light week for economic data, investors fixed their attention on Thursday’s Consumer Price Index release.
  • According to the Commerce Department, consumer prices slowed more than forecast in October due to significant declines in used vehicle and medical services prices.
    • The core measure, which excludes the often-volatile food and energy components, also experienced softness, pulling back from a 40-year high and settling at a still robust 6.3% increase year-over-year.
    • Although the headline and core CPI levels remain well-above historical norms and the Federal Reserve’s 2% average target, analysts were quick to comment that the weaker-than-expected readings could provide room for the FOMC to slow the pace of increases at the coming meetings.
  • After a period of stabilization, consumer sentiment appears to be deteriorating.
    • The preliminary November reading of the University of Michigan’s Consumer Sentiment Index declined far greater than the consensus estimate to 54.7, a four-month low.
    • Measures of current conditions and future expectations declined, while inflation expectations moved higher amid rising interest rates and historically elevated inflation.

The look forward

  • Upcoming economic data releases
    • Empire Manufacturing Index – Tuesday
    • Producer Price Index – Tuesday
    • Retail Sales – Wednesday
    • Industrial Production – Wednesday
    • Housing Starts – Thursday
    • Building Permits – Thursday
    • Jobless Claims – Thursday
    • Philadelphia Fed Business Outlook Survey – Thursday
    • Existing Home Sales – Friday
    • Leading Index - Friday
  • Upcoming Federal Reserve Speakers
    • Brainard, Williams – Monday
    • Harker, Cook, Barr – Tuesday
    • Williams, Barr, Waller – Wednesday
    • Bullard, Bowman, Mester, Jefferson, Kashkari – Thursday
    • Collins - Friday

Rates snapshot

Rates Snapshot 11 14 22

Market implied policy path (overnight indexed swap rates)

Market Implied Policy Path 11 14 22

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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