Rates rise as Fed officials preach patience

Rates climb amid strong service economy data, “patient” Fed

• Treasury yields rebounded last week after falling notably the week prior, amid a much better-than-expected ISM Services Index reading and a robust Fed official speaking calendar.

Hedging activity mixed in the first week of September

• Clients implemented a balanced mix of balance sheet hedging strategies during the holiday-shortened week.

ISM Services report tops expectations, sends rates higher

• Although economic data releases were in short supply last week, market participants reacted strongly to the much better-than-expected ISM Services Index release, among others.

Rates climb amid strong service economy data, “patient” Fed

• Treasury yields rebounded last week after falling notably the week prior, amid a much better-than-expected ISM Services Index reading and a robust Fed official speaking calendar.
• The 2-year yield climbed 11 basis points during the week to 4.98%, while the 10-year yield rose a more modest eight basis points to 4.26%.
• The more substantial increase at the short-end flattened the curve and sent the 2s/10s basis below its yearly average of -0.68%.
• A host of Federal Reserve officials held speaking engagements last week, and most expressed a need for patience as we enter the latest stage of the monetary policy cycle.
• Boston Fed President Susan Collins and Fed Governor Christopher Waller suggested the policy rate could be at its peak, with Waller emphasizing a desire to “proceed carefully” given that “there is nothing that is saying we need to do anything imminent anytime soon.”
• Cleveland Fed President Loretta Mester took a slightly more hawkish stance, arguing that the FOMC may “have to go a bit higher” to ensure price pressures move toward the Fed’s 2% target.
• Since Fed Chair Powell’s Jackson Hole speech at the end of August, most officials have expressed a view that the FOMC is now near to or at the end of the historic tightening cycle that began in the first quarter of last year.
• Last week’s solid data and the continued “higher for longer” narrative pushed by Fed officials drove market participants to increase their expectations slightly for a final 25 basis point hike in 2023.
• As of Friday’s close, market participants placed a roughly 50% probability on a hike before year-end but saw virtually no chance of a hike at the next FOMC monetary policy meeting in late September.

Hedging activity mixed in the first week of September

• Clients implemented a balanced mix of balance sheet hedging strategies during the holiday-shortened week.
• Financial institutions protecting their balance sheets against a rising rate environment continue to represent the lion’s share of hedging activity crossing our balance sheet strategies desk this year, and we saw more of that activity last week.
• Fair value hedging strategies leveraging the improvements afforded by the Portfolio Layer Method (PLM) proved most popular with clients looking to either portfolios of fixed-rate loans or fixed-rate AFS securities as support for the hedge accounting relationship.
• Wholesale borrowing hedging remains popular given the increased reliance on wholesale funding across the banking sector, but lags PLM implementations this year.
• Clients protecting against a falling interest rate environment increased activity levels last week due to the rise in rates and the relative improvement in the economics of those transactions.
• Looking at the balance sheet items used to support these transactions, most clients have leveraged floating-rate loan portfolios, with back-to-back swap programs typically serving as a good host, while others have utilized fixed-rate term borrowings in smaller numbers.

ISM Services report tops expectations, sends rates higher

• Although economic data releases were in short supply last week, market participants reacted strongly to the much better-than-expected ISM Services Index release, among others.
• The August ISM Services Index report topped all estimates in Bloomberg’s survey of economists before the release and rose to a six-month high.
• New orders and hiring levels led the charge higher and pushed the index further into expansionary territory.
• Unlike the manufacturing industry, the service economy has shown strength since the early days of the pandemic, experiencing only one contractionary ISM reading since the summer of 2020.
• Although market participants welcomed the strong ISM data, the report also suggested price pressures are firming as the “prices paid” component of the report moved higher.
• On the other hand, S&P Global’s measure of the U.S. service economy slipped to its lowest reading since January 2023 but, notably, remained in expansionary territory for the seventh consecutive month.
• Interestingly, the inflation component of this report contradicted the ISM release and fell to its lowest level since February 2023.

The look forward

Upcoming economic data releases

• Consumer Price Index – Wednesday
• MBA Mortgage Applications – Wednesday
• Retail Sales – Thursday
• Producer Price Index – Thursday
• Jobless Claims – Thursday
• Empire Manufacturing Index – Friday
• Industrial Production – Friday
• University of Michigan Consumer Sentiment – Friday

Upcoming Federal Reserve Speakers

• No speakers – blackout period before September 20 FOMC monetary policy meeting

Rates snapshot

Market implied policy path (overnight indexed swap rates)