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Market Update

Treasuries rise after hot CPI release

Date:
June 13, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

Treasury yields across the curve moved notably higher last week, while the major U.S. equity indices continued to decline, as market participants digested the latest inflation data and placed bets for a more hawkish Federal Reserve.

Interest Rates

  • After trading in a relatively narrow band for most of the week, Treasury yields moved sharply higher following Friday's expectation-beating release of the May Consumer Price Index (CPI) with the two-year Treasury yield increasing 40 basis points over the week to 3.06%.
    • The curve flattened notably last week, reversing the steepening moves seen since late May, as the 2s/10s basis compressed 21 basis points to 0.09%, the lowest level since early April.
    • Although the Fed-watched five-year forward, five-year breakeven inflation rate moved modestly lower last week, medium-term inflation expectations accelerated considerably with the five-year breakeven inflation rate increasing over 15 basis points to end the week at 3.16%.
  • Looking at Fed Funds futures pricing at the close on Friday, market participants now see the Federal Funds Target Range 2.5% higher from current levels by the year’s end, up from an expectation of 2% higher the week prior.
    • Notably, a 50-basis point hike in September is now fully priced in and current market pricing implies that a 75 basis point hike in July could be in the offing. Investors saw a 25 basis point hike as the most likely scenario for the September meeting before Friday’s CPI release.
  • Finally, last week’s rate increase saw real yields across the curve turn higher with the five-year real yield crossing into positive territory for the first time since late March 2020 and now sits at 0.12%.

Trading commentary

  • After seeing a flurry of activity the week prior, hedging activity across our balance sheet risk management desk remained significantly elevated last week as clients looked to fine-tune risk positions in the face of significant economic uncertainty.
  • Hedging strategies structured to pull income forward and protect against a drop in interest rates remained the most popular, with many clients using swap and option products to achieve the desired change in risk position.
    • Specifically, we saw several clients execute receive-fixed interest rate swaps using the floating-rate loan portfolio as the hedge vehicle. While tenor selection varies widely across our client base, we have seen many clients execute at the four to six-year point of the curve.
  • Although the lion’s share of hedging activity has been geared toward a downturn in rates, we continue to see significant activity in the other direction, with clients primarily using pay-fixed interest rates and caps to protect against a further increase in interest rates.
    • The recent upgrade to the fair value hedging accounting model has proven very attractive for many clients as they deploy strategies to protect further TBV and OCI degradation using the new Portfolio Layer Method.
  • Hedging activity on the back-to-back trading desk moderated slightly to start the week after a very busy month-end period but accelerated during the back half of the week as borrowers looked to lock-in long-term fixed-rate financing in the face of a persistently high inflationary environment.

Non-interest income growth picks up at big financial institutions, falls at small financial institutions

  • According to S&P Capital IQ, financial institutions over $10 billion in assets have seen growth in non-interest income levels in the last year, but financial institutions under $10 billion in assets have seen declines.
    • Looking at the data, institutions over $10 billion in assets saw a 3.5% increase in non-interest income in the last year, while institutions under $10 billion in assets saw a 13.2% decline in non-interest income during the same period.
  • While smaller institutions have seen declines in the last year, in aggregate, U.S. financial institutions have seen non-interest income growth far outpace net interest income growth since 2019 with U.S. institutions experiencing 17.2% non-interest income growth in the last three years compared to a more modest 0.89% net interest income growth in the same three-year period.

Economic data

  • Although several high-profile updates dotted the economic calendar last week, Friday’s release of the Consumer Price Index overshadowed all other economic updates.
  • According to the Labor Department, consumer prices rose 1% in May, topping the consensus estimate and far outpacing the 0.3% increase reported in April.
    • Looking at the report, many of the essentials saw the largest increases, with shelter, food, and energy costs rising considerably on both a monthly and yearly basis.
    • The core CPI measure, which excludes the food and energy components, rose a robust 0.6% in May, slightly above expectations and in line with April’s reading.
    • While many market participants speculated that inflation may be peaking, Friday’s release largely dashed those hopes and investors increased bets that the Federal Reserve will need to act even more aggressively to combat the decades-high inflationary environment.
  • The persistent rise in consumer prices is starting to dampen consumer sentiment considerably.
    • The University of Michigan’s preliminary June consumer sentiment reading saw the Index drop 8.2 points to 50.2, the lowest level on record.
    • Notably, long-term inflation expectations are becoming unanchored as high inflation persists with the consumers surveyed expecting inflation to run at 3.3% five to10 years from now, far above the 2.5% average expectation in the five years leading up to the pandemic.

The look forward

Upcoming economic data releases

  • Producer Price Index - Tuesday
  • Empire Manufacturing Index - Wednesday
  • Retail Sales - Wednesday
  • Building Permits - Thursday
  • Housing Starts - Thursday
  • Philadelphia Fed Business Outlook Survey - Thursday
  • Jobless Claims - Thursday
  • Industrial Production - Friday
  • Leading Index - Friday

                                              Upcoming Federal Reserve speakers

                                              • Brainard - Monday
                                              • FOMC Monetary Policy Meeting - Tuesday / Wednesday
                                              • Chair Powell Press Conference - Wednesday
                                              • Chair Powell - Friday
                                              • Waller - Saturday

                                              Rates snapshot

                                              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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