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Market Update

Rates rise to end a historic year in the capital markets

Date:
January 3, 2023
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

As 2022 drew to a close, Treasury yields moved notably higher to finish the year, capping an end to a historic year in the capital markets, as investors digested the latest economic data, policy commentary from Federal Reserve officials, and the evolving COVID-19 developments from China.

Interest rates

  • Treasury yields across the curve accelerated to end the year, with the 10-year Treasury yield rising 40 basis points in the final two weeks of the year to finish at 3.88%, 223 basis points higher than where it began the year.
    • To put 2022’s moves into more perspective, movement on the short end of the curve was most pronounced as market participants recalibrated their policy rate expectations substantially over the course of the year.
    • The 2-year Treasury yield experienced far-greater rate movements in 2022 compared to the 10-year, rising an even more substantial 365 basis points over the year to finish at 4.41%.
  • Although rates charged upward to end the year, the 2-year and 10-year yields remain notably lower than the recent highs experienced in mid-November.
    • Despite the run-up at the long end of the curve, the 2s/10s basis remains substantially inverted at -0.55%, down from the record levels seen in mid-December but far more inverted than the yearly average of -0.05%.
  • Looking at Fed Funds futures pricing at year end, market participants expect the policy rate to rise another 50 basis points by mid-2023 before giving up those moves and declining modestly at the end of 2023 to approximately current levels.
    • As we move into 2023, market participants will be paying close attention to the divergence that exists between Fed policy rate expectations outlined in the dot plot versus market expectations.

Trading commentary

  • Hedging activity remained robust through the end of the year, although activity slowed somewhat from levels seen earlier in the month.
  • As mentioned previously, strategies designed to protect against a falling interest rate environment continue to experience the greatest share of executions.
    • While plain vanilla receive-fixed swaps pointed at the floating-rate commercial real estate portfolio are most often utilized to accomplish the economic and accounting objectives, we have seen clients continue to investigate and execute costless collars as an alternative to the more familiar swap-based strategies.
  • Wholesale funding hedges also have increased significantly in the fourth quarter as clients look to lock in the cost of a portion of their wholesale funding base in the face of rapidly rising interest rates, particularly at the short end of the curve.
    • Although many borrowing types are utilized to achieve favorable hedge accounting treatment, we most often see clients pair a shorter-term SOFR-based FHLB advance with a pay-fixed swap to synthetically create a longer-term fixed-rate borrowing position at a cheaper cost than traditional alternatives.
    • In recent weeks, we have also seen increased use of the fair value hedging framework improvement, the Portfolio Layer Method, as clients look to hedge their rising interest rate exposure but leverage the asset side of the balance sheet to achieve the hedge accounting objectives rather than utilizing wholesale borrowings.

Economic data

  • Market participants were the beneficiaries of a light economic calendar to close the year.
  • The manufacturing outlook remained cloudy after two regional surveys released last week painted a mixed picture of the industry.
    • The Dallas Fed Manufacturing Activity Index notched its eighth consecutive contractionary reading, falling notably below expectations which called for an improvement, as reductions in new orders and capital expenditures outweighed gains in production and shipment.
    • The Richmond Fed Manufacturing Survey offered a bright spot, however, moving into expansionary territory for the first time in three months and performing far better than analyst expectations.
  • Finally, jobless claims ticked slightly higher for the week of December 24th, in line with the consensus estimate.
    • Despite the modest pick-up in the last week, current jobless claims levels sit very close to the yearly average of 214,000 claims.

The look forward

  • Upcoming economic data releases
    • S&P Global U.S. Manufacturing PMI – Tuesday
    • Construction Spending – Tuesday
    • ISM Manufacturing Index – Wednesday
    • ADP Employment Report – Thursday
    • Jobless Claims – Thursday
    • S&P Global U.S. Service / Composite PMIs – Thursday
    • December Non-Farm Payroll Report – Friday
    • Factory Orders – Friday
    • Durable Goods Orders – Friday
  • Upcoming Federal Reserve Speakers
    • FOMC December Meeting Minutes – Wednesday
    • Barkin – Friday

Rates snapshot

Rates Snapshot 1 3 23

Market implied policy path (overnight indexed swap rates)

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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