Treasury curve steepens, U.S. credit rating downgraded

Curve steepens amid solid labor report, U.S. credit rating downgrade

• Bucking the trend experienced in the prior two weeks, the Treasury curve steepened notably last week as the front of the curve dropped, and the long end increased.

Liability-sensitive clients continue hedging activity

• Hedging activity continued at a brisk pace as we entered August, with most clients protecting against further increases in interest rates

U.S. credit rating downgraded

• In a high-profile move that garnered significant financial media attention, Fitch Ratings downgraded the U.S. government’s credit rating from AAA to AA+ last week.

Labor market remains strong, manufacturing activity continues to decline

• Despite a robust economic calendar last week, investors focused their attention heavily on Friday's release of the July non-farm payroll release.

Curve steepens amid solid labor report, U.S. credit rating downgrade

• Bucking the trend experienced in the prior two weeks, the Treasury curve steepened notably last week as the front of the curve dropped, and the long end increased.
• The 2-year yield fell nine basis points to 4.78%, while the 10-year yield crossed the psychologically-significant 4% level, increasing nine basis points to finish the week at 4.05%.
• The diverging moves at opposite ends of the curve sent the 2s/10s basis to -0.73%, the highest level since late May.
• Returning from the blackout period enforced before the FOMC monetary policy meeting the week prior, several Federal Reserve officials held speaking engagements throughout the week.
• The week’s commentary broadly suggested that officials hold a slight bias toward continuing to raise rates as inflation slows but remains elevated in a historical context.
• Chicago Fed President Austan Goolsbee said recent inflation reports are "fabulous news" but cautioned that "we have seen progress for a short period before, like last summer, that proved to be false improvements" and would like to see a continued drop in inflation before halting rate increases.
• Atlanta Fed President Raphael Bostic struck a more cautious tone last week, arguing that the FOMC has made "significant progress" in its inflation battle and warrants a "cautious, patient, and resolute" approach to future monetary policy decisions. However, he noted that he would have "grudgingly" voted in favor of the FOMC's ultimate decision to raise rates at the end of July had he been a voter.
• On the other hand, market participants expect a more dovish Fed policy response than the latest Fed dot plot suggests.
• Looking at Fed funds futures pricing on Friday, investors currently place only a 30% probability of another 25 basis point hike this year and expect the first Fed rate cut to materialize late in the first quarter 2024.

Liability-sensitive clients continue hedging activity

• Hedging activity continued at a brisk pace as we entered August.
• Liability-sensitive institutions protecting against further increases in interest rates continue to represent the lion’s share of hedging activity crossing our balance sheet strategies desk.
• Although some clients have utilized option products, plain vanilla pay-fixed interest rate swaps are the most popular hedging instrument used year-to-date in these strategies.
• From the hedge accounting lens, most clients have utilized the flexibility afforded by the Portfolio Layer Method, choosing to leverage fixed-rate assets in the hedging accounting relationship. However, we continue to see substantial wholesale borrowing hedging, most commonly short-term FHLB advances or brokered CDs.
• Notably, asset sensitive clients have returned recently as rates have risen considerably since early May and the economics of these strategies have improved.
• Consistent with the hedging activity experienced last year, most asset-sensitive clients utilize floating-rate loan portfolios in the hedge accounting relationship and deploy a roughly balanced mix of receive-fixed interest rate swaps and options products like floors and costless collars.
• Nonetheless, we have noted an increase in institutions exploring retail CD hedging as bank customers have leveraged these products in more volume this year in aggregate.

U.S. credit rating downgraded

• In a high-profile move that garnered significant financial media attention, Fitch Ratings downgraded the U.S. government’s credit rating from AAA to AA+ last week.
• In the release announcing the downgrade, Fitch Ratings cited “expected fiscal deterioration over the next three years” and “repeated debt limit standoffs and last-minute resolutions” as reasons, among others, for the lower credit rating.
• Last week’s downgrade is only the second U.S. government credit rating downgrade in history, with Standard and Poor’s lowering in 2011 marking the only other instance.

Labor market remains strong, manufacturing activity continues to decline

• Despite a robust economic calendar last week, investors focused their attention heavily on Friday's release of the July non-farm payroll release.
• According to the Labor Department, the U.S. economy added 187,000 jobs in July, modestly below expectations but nearly identical to the downwardly-revised figures reported for June.
• Notably, average hourly earnings topped expectations and advanced at the same 0.4% monthly pace seen in June.
• The report suggested the labor market remains strong in the face of elevated interest rates, and some analysts pointed to an increased likelihood that the Federal Reserve engineers the coveted “soft-landing” scenario for the U.S. economy based on recent economic data.
• According to the latest national ISM Manufacturing survey, U.S. factory activity contracted in July, marking the ninth consecutive month in contractionary territory.
• Although new orders and production measures improved in July, they remained in contractionary territory and a gauge of exports fell to its most depressed level in 2023.

The look forward

Upcoming economic data releases

• Trade Balance – Tuesday
• Wholesale Inventories – Tuesday
• MBA Mortgage Applications – Wednesday
• Consumer Price Index – Thursday
• Jobless Claims – Thursday
• Producer Price Index – Friday
• University of Michigan Consumer Sentiment – Friday

Upcoming Federal Reserve Speakers

• Bostic, Bowman – Monday
• Harker, Barkin – Tuesday
• Bostic, Harker – Thursday

Rates snapshot

Market implied policy path (overnight indexed swap rates)