Rates rise as Fed meeting looms

Short end rises as Fed meeting looms

• After dropping notably in the wake of the prior week’s tamer-than-expected inflation readings, Treasury yields increased modestly last week, with the most significant moves seen at the front end of the curve.

Liability-sensitive clients continue hedging in Q3

• Liability-sensitive hedging strategies gained steam relative to asset-sensitive strategies last week after seeing a balancing of activity in the final months of Q2 and the beginning of Q3.

Large U.S. financial institutions report second-quarter earnings

• As we near the end of the first month of the third quarter, financial institutions are well underway in reporting second quarter earnings.

Retail sales slow, manufacturing data weak

• In a light week of economic releases, investors reacted to updated retail sales figures and two major regional manufacturing surveys.

Short end rises as Fed meeting looms

• After dropping notably in the wake of the prior week’s tamer-than-expected inflation readings, Treasury yields increased modestly last week, with the most significant moves seen at the front end of the curve.
• The 2-year Treasury yield rose eight basis points to 4.82%, while the 10-year Treasury rose only one basis point to end the week at 3.84%.
• The outsized gains at the short end sent the 2s/10s basis deeper into inverted territory, settling at -0.98%.
• Investors were left without commentary from Fed officials last week as they entered the blackout period leading up to the highly anticipated FOMC monetary policy meeting.
• Nonetheless, market participants continue to price in a 25 basis point hike as the most likely outcome after Wednesday’s meeting.
• Looking at Fed Funds futures pricing, investors expect the FOMC will break from its pause and raise the target range to 5.25% - 5.50%.
• After the July meeting, the waters get cloudy, and investors have far less conviction about the next step for monetary policy.
• Market participants are placing a roughly 30% probability on another 25 basis point hike in 2023 after July’s assumed 25 basis point move and no longer expect rate cuts in 2023, consistent with the most recent forecasts from the FOMC.

Liability-sensitive clients continue hedging in Q3

• Our hedging desk has continued to see significant volumes as Q3 gets underway.
• Liability-sensitive hedging strategies gained steam relative to asset-sensitive strategies last week after seeing a balancing of activity in the final months of Q2 and the beginning of Q3.
• As noted previously, most of these rising rate hedging strategies leverage fixed-rate asset portfolios via the Portfolio Layer Method or traditional short-term wholesale funding sources to achieve favorable hedge accounting treatment.
• The recent rise in interest rates prompted many asset-sensitive clients to re-explore hedging opportunities, given the improved initial economics compared to earlier this year.
• Although plain vanilla interest rate swaps are historically the most popular vehicle for hedging rate risk, many asset-sensitive clients have recently utilized option products such as interest rate floors and costless collars.
• On the customer hedging front, borrowers have become increasingly comfortable executing longer-term hedges as the expectation that rates will need to stay higher for longer solidifies.
• Year-to-date, many borrowers have looked to only hedge up to the 5-year point. However, of late, we’ve noticed more borrowers being comfortable going out 7 or 10 years as rates have stabilized over the last couple of months. In what can often be a slower month for customer hedging, volume on our desk in July has been extremely high.

Large U.S. financial institutions report second-quarter earnings

• As we near the end of the first month of the third quarter, financial institutions are well underway in reporting second quarter earnings.
• JPMorgan, Wells Fargo, and Citigroup each raised their 2023 net interest income (NII) projections upon the release of second-quarter financials.
• JPMorgan Chairman and CEO Jamie Dimon cautioned that “betas are going to go up,” but CFO Jeremy Barnum indicated that the improved NII guidance is driven by “deposit reprice expectations” and expectations for the rate environment.
• More broadly, rising deposit costs have been cited across the industry as a source of net interest margin compression.
• According to an analysis conducted by S&P Capital IQ, certificate of deposit (CD) balances have increased a robust 30.6% quarter-over-quarter at publicly traded institutions that have released second-quarter earnings thus far.
• The reported increase in CD balances is consistent with the increased wholesale borrowing hedging activity we have seen across our strategies desk this year.

Retail sales slow, manufacturing data weak

• In a light week of economic releases, investors reacted to updated retail sales figures and two major regional manufacturing surveys.
• According to the Commerce Department, retail sales decelerated in June, rising 0.2% compared to the revised 0.5% monthly pace in May.
• Notably, 7 out of the 13 measured categories recorded gains in June, and the “controls group” sales, utilized in the government’s GDP calculation, advanced double last month’s increase.
• Attention now turns to next week’s first estimate of second-quarter GDP.
• Last week’s regional manufacturing releases painted a mixed picture of the industry outlook.
• The Empire Manufacturing Index defied expectations for a negative reading and remained in expansionary territory but declined from levels reported in June.
• New York manufacturers’ views on business conditions were mixed, with 29% reporting improving conditions, while 27% reported worsening conditions.
• Conversely, the Philadelphia Fed Business Outlook Survey fell below expectations and remained in contractionary territory as new orders and shipments declined over the month.

The look forward

Upcoming economic data releases

• Chicago Fed National Activity Index – Monday
• S&P Global U.S. Manufacturing / Services PMIs – Monday
• Conference Board Consumer Confidence Index – Tuesday
• Richmond Fed Manufacturing Index – Tuesday
• MBA Mortgage Applications – Wednesday
• New Home Sales – Wednesday
• Second-Quarter GDP (1^st estimate) – Thursday
• Durable Goods Orders – Thursday
• Jobless Claims – Thursday
• Wholesale Inventories – Thursday
• Personal Income / Spending – Friday
• University of Michigan Consumer Sentiment – Friday

Upcoming Federal Reserve Speakers

• Fed Chair Jerome Powell Post-FOMC Press Conference – Wednesday

Rates snapshot

Market implied policy path (overnight indexed swap rates)