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Market Update

Weak economic data heightens recession fears

Date:
July 5, 2022
  • william smith headshot

    Authors

    Bill Smith

    Associate Director
    Balance Sheet Risk Management

    Financial Institutions | Kennett Square, PA

Summary

Treasury yields and U.S. equity indices took another leg lower last week as a slate of weak economic data releases heightened fears that a hawkish Federal Reserve will push the U.S. economy into a recession.

Interest rates

  • Treasury yields continued to decline, and the curve continued to flatten last week with the 10-year Treasury yield falling approximately 25 basis points to end the week below the psychologically significant 3% level at 2.88%, a far cry from the multi-year high of 3.49% seen just two weeks ago.
    • The 2s/10s basis, a popular measure for measuring the Treasury curve’s steepness, fell modestly to 4 basis points, roughly 20 basis points lower than the levels seen at the start of the month and over 60 basis points lower than the yearly average.
  • Much of the decline in interest rates seen this month has been a result of market participants recalibrating their bets for Federal Reserve rate hikes in the next year.
    • While expectations for rate hikes in 2022 held steady last week, market participants now see zero rate hikes in 2023 and rate cuts starting in the June–July 2023 timeframe, a stark contrast from the expectation for a 25-basis-point hike in February 2023 at the end of the week prior.
  • Inflation expectations have also played a role in the downturn in Treasury yields as all of the major breakeven measures declined last week.
    • The Fed-preferred 5-year forward, 5-year breakeven inflation rate and the 10-year breakeven inflation rate each fell over 20 basis points week over week, continuing the trend that started in mid-June.
  • Finally, real yields at the 10-year point and shorter turned lower albeit to a lesser extent than nominal yields last week.
    • The 10-year real yield fell a modest three basis points to end the week at 0.54%, while the 5-year real yield declined 7 basis points to 0.28%.

Trading commentary

  • As noted in previous editions, our balance sheet risk management desk continues to see hedging activity in both directions with asset-sensitive clients looking to pull income forward and prepare for a downturn in interest rates, and liability-sensitive clients looking to lock in current rates and protect their tangible book value and tangible common equity metrics from further degradation as a result of declines in Accumulated Other Comprehensive Income.
    • Down-rate hedging strategies continue to remain slightly more popular than the up-rate hedging alternatives, leveraging the floating-rate loan portfolio, primarily 1-month Libor and Prime-based assets, to accomplish both the economic and accounting objectives.
    • The ability to pull income forward, smoothing earnings in an expected rising rate environment, has proved attractive for many of our clients.
      • The 5-year part of the curve currently offers roughly 115 basis points of relative compensation when compared to current index levels.
  • Last week we also saw up-rate hedging activity with some clients utilizing the new flexibility afforded by the upgrade to the fair value hedging accounting framework via the Portfolio Layer Method (PLM).
    • Using the PLM strategy, these clients were able to designate either large portions of or the entire AFS investment portfolio in a hedge accounting relationship, providing a substantial cushion for current hedges and allowing for continued hedging within the same designated portfolio should the opportunity prove attractive.
  • Separately, our back-to-back trading desk saw significant hedging activity last week as borrowers and financial institutions alike rushed to get deals done before the end of the quarter.
    • As we look at the activity since the turn of the year in the post-LIBOR origination environment, financial institutions across our client base have primarily selected CME Term SOFR as the preferred LIBOR-replacement index.

Wary of rising interest rates, financial institutions slow bond purchases in Q1

  • As we close out the second quarter, we look back to the securities portfolio purchase activity seen in the first quarter.
    • According to S&P Capital IQ, bond portfolios grew just 0.2% in aggregate quarter-over-quarter at U.S. financial institutions to start 2022.
    • Despite growing excess liquidity in the same timeframe, securities portfolio purchases pulled back as market participants started to expect a series of Federal Reserve rate hikes in 2022 to combat a decades-high inflationary environment.
      • Notably, security purchases at the longer end of the curve saw the largest declines as Treasury teams shied away from longer-duration, more price-sensitive instruments.
  • Nonetheless, financial institutions across the country look poised to see higher net interest margins in the coming months as new originations benefit from higher interest rates and deposit betas remain low.

Economic data

  • A host of economic updates were released last week with the lion’s share of updated readings pointing to a slowing U.S. economy.
  • After several regional manufacturing readings posted declines earlier in the week, the national ISM Manufacturing Index fell to a two-year low in June as new orders declined across the country, consistent with the commentary offered in both the Philadelphia Fed Business Outlook Survey and the Richmond Fed Manufacturing Index earlier in the month.
    • Although the inflation reading included in the ISM survey eased somewhat, many analysts voiced concerns that the measure remains near the top-end of historical levels.
  • Tuesday’s release of the Conference Board Consumer Confidence Index also soured investor sentiment as the reading fell more than the consensus estimate to 98.7, a 16-month low.
    • The decline in consumer confidence comes as consumers’ expectations for the economic outlook have dwindled considerably in recent months in the face of a historically elevated inflation environment.
  • Finally, the third and final reading of first-quarter GDP came in slightly below expectations posting a 1.6% decline from last quarter.
    • While analysts have highlighted that some of the contraction in first-quarter GDP can be attributed to technical factors, expectations for the second quarter have also weakened considerably in recent weeks.
      • The Atlanta Fed’s GDPNow tool, which attempts to forecast the current quarter’s GDP in real-time, now predicts GDP to contract 2.2% in the second quarter, a stark contrast to the 0.0% growth expectation seen the week prior.

The look forward

  • Upcoming economic data releases
    • Factory Orders - Tuesday
    • Durable Good Orders - Tuesday
    • FOMC June Meeting Minutes - Wednesday
    • S&P Global U.S. Composite PMI - Wednesday
    • Jobless Claims - Thursday
    • Wholesale Inventories - Friday
    • June Non-Farm Payroll Report - Friday
  • Upcoming Federal Reserve Speakers
    • Williams - Wednesday
    • Waller, Bullard - Thursday
    • Williams - 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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