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Market Update

Treasury yields push higher amid hot inflation

Date:
March 14, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

After rallying the week prior, Treasuries sold off last week with the 10-year Treasury rising over 25 basis points on the back of rising inflation expectations as market participants digested February inflation data, soaring commodity prices, and the latest developments from the war in Ukraine.

Interest rates

  • Volatility continued in earnest last week with Treasury yields across the curve pushing substantially higher, erasing the moves from the week prior’s rally.
    • Surging commodity prices and disruptions emanating from the war in Ukraine dominated headlines and sentiment last week, prompting investors to increase bets for inflation and Federal Reserve rate hikes.
    • Looking at the Fed Funds futures market, rate hike expectations pulled forward last week with market participants now pricing in over seven 25 basis point hikes by February 2023 compared to under six 25 basis point hikes fully priced in for the same timeframe just one week ago.
      • Last week’s moves higher were largely balanced across the curve with both the two-year and 10-year Treasury rising approximately 25 basis points on the week to 1.75% and 20%, respectively.
      • While the 2s/10s basis has been narrowing since mid-January, the 2s/10s basis remained roughly unchanged week over week at 25 basis points and continued to hover near the lowest levels seen since early March 2020.
  • After sitting near the yearly average to start the year, inflation expectations increased significantly last week with the Fed-watched 5-year forward, 5-year breakeven inflation rate rising over 25 basis points to 2.46%, nearly 50 basis points above the Fed’s average inflation target.

    Trading commentary

    • As we have mentioned previously, the pickup in yields since the turn of the year and the heightened volatility stemming from the war in Ukraine have driven elevated hedging activity.
      • Last week on our balance sheet desk, we saw several clients go to market entering into receive-fixed interest rate swaps to monetize the relative steepness at the front end of the yield curve and mitigate asset sensitivity.
        • Down rate hedging strategies have become increasingly popular in the current environment, with clients often staying short, entering into hedges with two to three-year maturities and receiving 140-160 basis points of initial compensation, depending on the specific trade structure.
      • Conversely, we continue to see clients look to position for further increases in interest rates with several clients hedging expected future wholesale funding needs and others mitigating OCI risk in the investment portfolio.
    • Similarly, the rise in volatility and the expectation for several Federal Funds rate hikes this year has driven a pickup in activity on our back-to-back trading desk as commercial borrowers look to lock in long-term fixed-rate financing.
      • As we approach the end of the first quarter, we have seen muted demand from borrowers looking to amend legacy LIBOR-based contracts to Term SOFR given the underlying economics.
    • Finally, we have seen a modest drop in LIBOR liquidity as we move through the first quarter, with dealer bank pricing widening out compared to the end of 2021.

      Big banks raise Q1 revenue guidance

      • Several large financial institutions raised revenue guidance for Q1 and full-year 2022 last week on the back of a better-than-expected pickup in loan demand and heightened expectations for Federal Funds rate hikes.
      • Truist Financial Corp. indicated that the bank now expects to see net interest income growth near the top end of the 2-4% range given in January after seeing a strong start to commercial lending in 2022 and raising their 2022 expectation for 25 basis point rate hikes from two to five.
        • In an encouraging sign for the broader banking space, Truist CFO Daryl Bible hinted at an increase in commercial lending activity in the first quarter saying, “we’re getting good growth on the balance sheet in commercial,” and noting that, “February has been a really good month for us.”
      • U.S. Bancorp CFO Terrance Dolan offered similar comments on Wednesday, raising expectations for Q1 net interest income growth and highlighting commercial and industrial (C&I) loan growth.
        • Speaking on the C&I activity to start the year, Dolan indicated a pickup in lending activity in the space saying, “Especially on the commercial and industrial side, there is a pent-up demand to be able to rebuild inventories, and we're starting to see some capital expenditure as well.”

      Economic Data

      • Economic data releases were light in quantity last week, but the February Consumer Price Index (CPI) release garnered significant attention from both the financial media and market participants.
      • According to the Labor Department, consumer prices increased 7.9% from a year earlier, higher than the consensus estimate and the fastest yearly increase in over 40 years.
        • Digging into the report, food, energy, and shelter prices served as the primary drivers for the monthly pickup with food prices rising 1%, energy prices rising 3.5%, and shelter costs rising 0.5% in February.
        • Notably, the recent surge in gasoline prices as a result of Russian sanctions was not captured in February’s report.
      • Excluding the volatile food and energy components, core prices rose a still robust 6.4%, a quicker yearly pace than seen in January’s report.
      • Unsurprisingly, rising prices appear to have dampened consumer sentiment.
        • According to the University of Michigan’s consumer sentiment gauge, sentiment has fallen in the early days of March, notching both the third consecutive monthly decline and the lowest reading since 2011.
        • Looking at the report, over 50% of respondents expect their income to lag inflation in the upcoming year, while roughly one-third of respondents expected their finances to worsen in the coming year, nearly double the share of respondents holding this expectation one year ago.
      • Looking ahead, analysts warned that next month’s gauge will likely turn further south as consumers digest additional increases to energy prices and the latest developments from the war in Ukraine

                      The look forward

                      Upcoming economic data releases

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

                                            Upcoming Federal Reserve Speakers

                                            • FOMC March Monetary Policy Meeting – Tuesday and Wednesday
                                            • Chair Powell Post-FOMC Meeting Press Conference – Wednesday
                                            • Barkin, Bowman – Friday

                                                                  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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