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Article

Rates higher on hawkish Fed

Date:
September 12, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

In a light week for economic data releases, Treasuries continued to sell off, while the major U.S. equity indices snapped a three-week losing streak as investors digested the hawkish comments of several Federal Reserve officials, including Federal Reserve Chair Jerome Powell.

Interest rates

  • Treasury yields moved notably higher across the curve last week, continuing the weeks-long sell off.
    • Although the curve flattened slightly, both the short end and the long end of the curve saw substantial increases with the 2-year Treasury yield rising 16 basis points over the week to end at 3.56%, while the 10-year Treasury yield rose a still-robust 13 basis points to 3.33%.
    • Despite flattening last week, the Treasury curve remains notably steeper than last month when the 2s/10s basis set a multi-decade low of -0.50%.
  • Federal Reserve officials continued to reinforce the hawkish message delivered at Jackson Hole late last month.
    • Chair Powell garnered the most attention on Thursday and kept the door open for a 75-basis-point hike, indicating that the Fed will act “forthrightly” in the face of decades-high inflation and emphasized that officials are “strongly committed” to restoring price stability.
    • Several other Fed officials expressed support for a 75-basis-point hike last week, including Chicago Fed President Charles Evans, who suggested that the FOMC “could very well do 75 in September.”
    • Looking at Fed Funds futures market pricing at the close on Friday, market participants are now seeing a 90% chance of a 75-basis-point hike at the next FOMC meeting on September 20–21 and now expect an additional 1.75% of policy rate increases from the current level by the end of the first quarter 2023, one more 25-basis-point hike than was priced in a week earlier.
  • Finally, inflation expectations continued to turn lower last week.
    • The Fed-preferred 5-year forward, 5-year breakeven inflation rate, as well as, the 5-year and 10-year breakeven inflation rates each experienced moderate declines.

Trading commentary

  • The persistent volatility experienced in the Treasury market has led to elevated hedging activity crossing our balance sheet risk management desk.
  • Last week, we saw several asset-sensitive clients capitalize on the weekslong run-up in interest rates and implement hedging strategies designed to protect against a downturn in interest rates.
    • While plain-vanilla interest rate swaps remain the most popular derivative instrument to hedge interest rate risk, we saw some clients utilize option products last week and purchase out-of-the-money interest rate floors.
    • Although nearly all the downrate hedging activity we have seen from our clients year-to-date has used the floating rate loan portfolio to achieve the desirable hedge accounting treatment, last week we saw a client receive hedge accounting on a pool of collateralized loan obligations currently tied to 3-month LIBOR.
  • Looking in the other direction, we continue to see clients use pay-fixed interest rate swaps to hedge pools of new mortgage originations using the flexibility afforded by the recent improvements to the fair value hedging framework in the form of the Portfolio Layer Method.

Despite slowing economy, credit portfolios remain strong

  • Although the U.S. economy has contracted in the first two quarters to start the year, U.S. financial institutions appear to be weathering the storm thus far.
    • After a surge in criticized loan balances in early 2020 at the start of the pandemic, criticized loan levels have declined in each of the ensuing 2 years and currently sit approximately $50 billion above the levels seen in 2019.
    • According to S&P Capital IQ, approximately 70% of the U.S. financial institutions with over $50 billion in assets have seen criticized loan balances fall sequentially.
  • While credit portfolios are seemingly intact, executives at large U.S. financial institutions have highlighted the tightening of credit standards in recent quarters and have advised caution in some segments of the commercial real estate landscape.

Economic data

  • After a slew of high-profile economic releases over the last several weeks, market participants took a breather last week receiving only a few notable updates.
  • Service sector releases painted a mixed picture of the service economy.
    • According to the ISM Services Index, the service economy remains in expansionary territory, moderately topping last month’s reading and defying analyst calls for a monthly decline.
    • The S&P Global Services PMI release was less encouraging, falling below the consensus estimate and notching the index’s fifth consecutive monthly decline.
      • August’s 43.7 reading marks the lowest reading for the index since June 2020 during the height of the COVID-19 pandemic restrictions.
  • Finally, jobless claims fell moderately below the consensus estimate and the prior week’s level to 222,000 claims.
    • The 222,000 claims reported for the week ending September 2 is the lowest reading since late May.

The look forward

  • Upcoming economic data releases
    • Consumer Price Index – Tuesday
    • Producer Price Index – Wednesday
    • Empire Manufacturing Index – Thursday
    • Retail Sales – Thursday
    • Jobless Claims – Thursday
    • Philadelphia Fed Business Outlook Survey – Thursday
    • Industrial Production – Thursday
    • University of Michigan Consumer Sentiment – Friday
  • Upcoming Federal Reserve Speakers
    • Federal Reserve Speakers are in the speaking engagement blackout period leading up to the September 20–21 FOMC monetary policy meeting.

Rates snapshot

Market implied policy path (Overnight indexed swap rates)

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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