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Market Update

Third quarter GDP tops expectations, Treasury yields turn lower

Date:
October 31, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

Treasury yields declined across the curve, while the major U.S. equity indices advanced as investors digested the latest economic releases and a busy third-quarter earnings calendar.

Interest rates

  • Treasury yields fell across a flatter curve last week.
    • The 10-year Treasury yield fell below the psychologically significant 4.00% level mid-week before rising on Friday to end the week at 4.01%, 18-basis-points lower than where it started the week.
    • After steepening significantly the week prior, the curve flattened notably last week as the 2s/10s basis inversion accelerated to -0.41%, approximately ten basis points flatter than the third quarter average.
  • With Fed officials in the blackout period before the early November FOMC monetary policy meeting, expectations for Fed policy action in the near-term remain mostly unchanged.
    • Looking at Fed Fund’s futures market pricing as of the close on Friday, market participants expect the FOMC to raise the Target Range by 75-basis-points on November 2 and 1.75% from current levels by the end of the first quarter.
    • Notably, investors expect the Fed to levy its first interest rate cut in the fall of 2023.
  • Finally, real yields also took a turn lower last week, with the 5 and 10-year real yields falling eight and 18 basis points, respectively.
    • Breakeven inflation rates moved lower across tenors last week, with the Fed-preferred 5-year forward, 5-year breakeven inflation rate declining ten basis points to 2.34%.

Trading commentary

  • Hedging activity continued at a blistering pace last week as our clients looked to fine-tune their interest rate risk positions in the face of global economic and geopolitical uncertainty.
  • Hedging strategies designed to protect against a falling interest rate environment continue to see the lion’s share of executions.
    • Approximately 80% of executions crossing our balance sheet strategies desk are hedging a decline in interest rates.
    • While the floating rate commercial loan portfolio has been historically the most oft-used balance sheet item to achieve favorable hedge accounting treatment for these strategies, we have seen increased use of floating rate securities as the balance sheet item, particularly CLOs, to achieve favorable hedge accounting treatment in recent weeks.
    • Swaps remain the primary derivative instrument used to hedge interest rate risk across our client base, but we have seen some clients implement floor spread and costless collar hedging strategies, structuring the options’ strikes to reach the desired payoff profile and price sensitivity.
  • Hedging for higher rates, while less popular than the alternative, has continued with most clients hedging in this direction implementing strategies through the funding channel, often extending the duration of a short-term SOFR-based FHLB advance with a pay-fixed interest rate swap or cap.
    • Compared to the fixed-rate alternative, a longer-dated swap coupled with a short-term FHLB advance often proves more cost effective by 20 – 40 basis points, depending on the tenor and FHLB.
    • Lastly, we have seen some clients desire to hedge the bond portfolio’s risk to OCI directly by hedging AFS securities and utilizing the new improvements to the fair value hedge accounting framework.

U.S. banks expect loan growth to continue in the fourth quarter

  • Third quarter earnings season is now well underway, and many of the largest U.S. financial institutions have reported earnings this month.
    • Continuing the trend established early in the earnings cycle with the largest U.S. banks, Bank of Hawaii, First Citizens, and Cadence Bank, all forecasted net interest margin to grow in the fourth quarter on the back of continued Fed tightening.
    • First Citizens highlighted their expectation for mid-single-digit loan growth for full year 2023, with CFO Craig Nix commenting that he feels “good about our earnings momentum heading into 2023.”

Economic data

  • Investors were the beneficiaries of several high-profile economic updates last week.
  • S&P Global’s preliminary Manufacturing and Services PMIs both plummeted from levels seen last month, highlighting the ongoing struggles in the U.S. economy’s manufacturing and services sectors
    • Digging into the manufacturing release, much of the decline can be attributed to a reduction in new orders, which hit its lowest level since May 2020.
  • After a brief period of stabilization, consumer sentiment soured in October, according to the Conference Board.
    • The Conference Board Consumer Confidence Index fell well below the consensus estimate and September’s reading as consumers face decades-high inflation and rapidly rising interest rates.
  • Finally, the U.S. economy snapped a two-quarter streak of declines and grew at a 2.6% annualized pace in the third quarter, well above the -0.6% annualized pace seen in the second quarter.
    • Looking forward, the Atlanta Fed’s GDPNow tool, which attempts to forecast the current quarter’s GDP in real-time, currently expects the U.S. economy to expand at a quicker 3.1% annualized pace in the fourth quarter.

The look forward

  • Upcoming economic data releases
    • MNI Chicago PMI – Monday
    • Dallas Fed Manufacturing Activity Index – Monday
    • S&P Global Manufacturing PMI – Tuesday
    • ISM Manufacturing Index – Tuesday
    • FOMC Rate Decision - Wednesday
    • ADP Employment Report – Wednesday
    • Jobless Claims – Thursday
    • Factory Orders – Thursday
    • Durable Goods Orders – Thursday
    • ISM Services Index – Thursday
    • October Non-Farm Payroll Report - Friday
  • Upcoming Federal Reserve Speakers
    • Powell Press Conference – Wednesday
    • Neal, Collins – Friday

Rates snapshot

October 31, 2022 rates snapshot

Market implied policy path (overnight indexed swap rates)

Market implied policy path October 31, 2022

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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