Rates rise after twin inflation reports

Rates rise on July inflation data

• After trending downward to start the week, Treasury yields rose across the curve in the final two days of the week as investors reacted to the latest Consumer Price Index (CPI) and Producer Price Index (PPI) releases.

Rising rate hedging continues amid pick-up in interest rates

• Despite the run-up in rates experienced in the last several weeks, liability-sensitive clients continue to protect their balance sheets against further increases in interest rates.

Inflation readings grab attention, consumer sentiment remains stable

• In a light week for economic data releases, market participants focused their attention on the high-profile July CPI and PPI reports released at the end of the week.

Rates rise on July inflation data

• After trending downward to start the week, Treasury yields rose across the curve in the final two days of the week as investors reacted to the latest Consumer Price Index (CPI) and Producer Price Index (PPI) releases.
• The 2-year and 10-year yields each increased 11 basis points to end the week at 4.89% and 4.16%, respectively.
• The equivalent moves at the short and long end of the curve left the 2s/10s basis unchanged at -0.73%.
• Although each end of the curve increased notably, the most significant moves came in the belly of the curve, with five and seven-year yields rising 16 basis points week-over-week.
• Several Federal Reserve officials held speaking engagements last week and offered mixed messages.
• Philadelphia Fed President Patrick Harker and New York Fed President John Williams suggested that the current policy rate level is sufficient to combat inflation effectively. Harker suggested he would favor no hike at the next meeting "absent any alarming new data" between now and then.
• On the other hand, some officials expressed a preference for more hikes.
• Fed Governor Michelle Bowman noted that recent inflation releases were "positive" but that additional rate hikes "will likely be needed" to combat inflation effectively and return inflation to the FOMC's 2% target.
• After the CPI release, San Francisco Fed President reiterated Bowman's sentiment, calling for additional rate hikes and arguing that the latest CPI report "is not a data point that says victory is ours."
• In recent weeks, market participants have increasingly sided with the "no hike" camp.
• Looking at Fed Funds futures pricing on Friday, market participants only place a 30% probability on another hike this year and forecast the first interest rate cut to occur in mid Q2 ‘24.

Rising rate hedging continues amid pick-up in interest rates

• Despite the run-up in rates experienced in the last several weeks, liability-sensitive clients continue to protect their balance sheets against further increases in interest rates.
• Although we saw significant wholesale borrowing hedging at the start of the year, we have seen a gravitation toward hedging fixed-rate assets in a Portfolio Layer Method (PLM) hedge accounting relationship in recent months.
• Looking at the assets used in PLM hedges, clients, in aggregate, have leveraged a roughly balanced mix of loans and securities, with derivative valuation geography often driving asset class choice.
• Nonetheless, we have seen a notable pickup in asset-sensitive clients exploring and executing strategies that protect against a falling interest rate environment.
• While many of these strategies still have negative carry given the market's expectation for rate cuts as early as the first half of next year, the economics of these strategies has improved significantly since mid-May as rates across the curve have risen.
• Customer hedging volumes have remained elevated to start August as banks continue to favor floating-rate loans with swaps over conventional fixed-rate loans.
• Borrowers continue to primarily swap the first few years of the forward curve in the hope that they’ll be able to refinance into a lower rate more easily in the future should rates fall from current levels.
• Similarly, borrowers in construction loans have increasingly looked to swap their anticipated draws, a strategy not seen often in the past low-rate environment, in order to remove some rate risk and capture the savings from positive carry that exist for most tenors.

Inflation readings grab attention, consumer sentiment remains stable

• In a light week for economic data releases, market participants focused their attention on the high-profile July CPI and PPI reports released at the end of the week.
• According to the Labor Department, headline CPI increased 0.2% in July, matching June's increase and marking the two smallest back-to-back monthly gains this year.
• The yearly figure increased to 3.2% in July but fell below the consensus expectation.
• The tame inflation data led some analysts to suggest that the FOMC could pause at the September meeting, the current baseline forecast of market participants according to Fed Funds futures.
• Separately, the PPI release topped expectations modestly in the headline and core monthly and yearly figures, droving rates higher on Friday.
• According to the latest University of Michigan survey, consumer sentiment remained stable in August.
• Measures of the current outlook improved slightly, but expectations for the future degraded somewhat, leading to a roughly unchanged reading.
• Interestingly, consumers’ expectations for inflation over the next year fell modestly, defying calls for a ten basis point increase and instead dropping ten basis points to 3.30%.

The look forward

Upcoming economic data releases

• Retail Sales – Tuesday
• Empire Manufacturing Index – Tuesday
• MBA Mortgage Applications – Wednesday
• Building Permits – Wednesday
• Housing Starts – Wednesday
• Industrial Production – Wednesday
• Jobless Claims – Thursday
• Philadelphia Fed Business Outlook Survey – Thursday
• Leading Index – Thursday

Upcoming Federal Reserve Speakers

• Kashkari – Tuesday
• FOMC Meeting Minutes – Wednesday

Rates snapshot

Market implied policy path (overnight indexed swap rates)