Treasury yields spike on hawkish Fed commentary

Treasury yields spike on hawkish Fed commentary

• Yields spiked sharply last week, with the short end climbing over 30 basis points.

Hedging activity increases despite rising rates

• Although rates have experienced a notable increase in May, many clients remain undeterred and are focused on protecting the balance sheet from continued rate increases or a protracted high-rate environment.

Manufacturing outlook worsens, retail sales disappoint

• Market participants reacted to two prominent manufacturing surveys and a mixed retail sales report.

Treasury yields spike on hawkish Fed commentary

• Yields spiked sharply last week, with the short end climbing over 30 basis points.
• The 2-year yield ended the week 30 basis points higher at 4.28%, while the 10-year yield climbed a smaller but still substantial 24 basis points to 3.7%
• The more significant moves at the short end of the curve continued to drive the 2s/10s basis lower to a four-week low.

• While several high-profile economic releases and debt ceiling negotiations influenced last week's rates movements, much of the increase resulted from a series of Federal Reserve commentary that appeared to suggest officials are conflicted on whether to pause or to hike at the next FOMC meeting in June.
  • Most officials acknowledged the lagged effects of monetary policy and the time it takes for interest rate changes to impact demand, but cautioned that inflation remains persistently elevated and that additional rate increases may be necessary.
  • In a highly anticipated speech on Friday, Jerome Powell opened the door for a June pause, arguing that tighter credit conditions lower the need for additional increases and that the FOMC "can afford to look at the data and the evolving outlook to make careful assessments."
• In light of the Fed commentary, market participants recalibrated their expectations for the Fed Funds rate significantly last week.

• Investors expect the FOMC will pause throughout the summer but now expect a "higher-for-longer" rate environment in the near term.
• Market participants slashed expectations for a significant bout of interest rate cuts in the coming fall and winter and now expect just two 25 basis point reductions by January 2024 compared to four just last week.

Hedging activity increases despite rising rates

• Liability-sensitivity clients drove the lion’s share of hedging activity across our strategies desk last week.
  • Although rates have experienced a notable increase in May, many clients remain undeterred and are focused on protecting the balance sheet from continued rate increases or a protracted high-rate environment.
  • As noted previously and consistent with the activity experienced last week, a healthy balance exists between clients leveraging the improvements to the fair value hedging framework in the form of the Portfolio Layer Method, and others utilizing the historically more traditional cash flow hedging framework against wholesale borrowings.
• We have seen our asset-sensitive clients return recently to explore and execute falling rate protection strategies, as the initial economics of these strategies has improved with the climb in yields.
• On the loan level hedging side, borrowers continue to primarily hedge the front end of the yield curve in the hope that rates will be lower than current levels after the next three to five years. Additionally, we’ve seen an uptick in borrowers on construction deals entering into forward-starting swaps to hedge their permanent phase interest rate. With the existing inversion in the yield curve, forward-starting swaps continue to carry significantly lower rates than analogous swaps that take effect immediately.

Manufacturing outlook worsens, retail sales disappoint

• According to the Empire Manufacturing Index and the Philadelphia Fed Business Outlook Survey, the manufacturing industry struggled in May.
• Although the Philadelphia Fed survey fared better than analysts expected, the sub-zero reading indicated worsening conditions in early May.
• The Empire survey performed even poorer, defying calls for a slight decrease and instead notching the worst month-over-month decline since April 2020 and sliding more than any analyst estimate.
• Retail sales rose 0.4% in April, the first monthly increase since January, but far short of the 0.8% consensus estimate.
  • While seven out of 13 measured categories increased in April, analysts quickly pointed out that retail sales figures are not adjusted for inflation and that much of the monthly increase in sales is attributed to price increases over the period.
• Finally, market participants received a slew of housing-related data that painted a mixed picture of the housing outlook.
• Housing starts increased more than expected, but building permits and existing home sales experienced monthly drops.

The look forward

Upcoming economic data releases

• S&P Global U.S. Manufacturing / Services PMI – Tuesday
• New Home Sales – Tuesday
• Richmond Fed Manufacturing Index – Tuesday
• FOMC May Meeting Minutes – Wednesday
• MBA Mortgage Applications – Wednesday
• Chicago Fed National Activity Index – Thursday
• Jobless Claims – Thursday
• 1^st Quarter GDP (2^nd estimate) – Thursday
• Personal Income / Spending – Friday
• Core PCE – Friday
• Durable Goods Orders – Friday
• University of Michigan Consumer Sentiment Index – Friday

Upcoming Federal Reserve Speakers

• Bullard, Daly, Bostic – Monday
• Logan – Tuesday
• Waller – Wednesday
• Collins – Thursday

Rates snapshot

Market implied policy path (overnight indexed swap rates)