Not so fast, my friend!
- Zach Zoia
- Oct 27, 2022
- 6 min read
Updated: Oct 28, 2022
Autumn is a beautiful time of year in New England as the weather cools and the leaves transform into orange and red hues. Throw in the return of college and professional football, and it is by far my favorite season of the year.
In the markets, there was speculation as the summer heat faded that inflation may be following that same trajectory: we would hit a terminal fed funds rate in the mid-3% range by year-end, with building momentum for potential rate cuts forthcoming as 2023 progressed.
Yet as we all know by now, the markets and the Fed were off… again.
The third straight 75bp rate increase by the Fed at their September meeting, as well as their “hawkish” tone and increased dot plot projections, set off another end of quarter bond market sell-off and quelled for now the narrative that this rising rate cycle may be nearing its end.
It reminded me a bit of the famous college football coach, Lee Corso. He is not widely remembered for his actual coaching record (73-85-6 in 15 seasons), but is known more for his 35-year career on television as an analyst, mostly on ESPN’s widely-watched College Gameday program each Saturday.
Before I had children, watching Coach and the rest of the crew was a staple of my fall Saturdays (not so much anymore 😊), and it was always worth watching the entire show, waiting for him to drop his inevitable signature line as the group made their predictions on who would win each game.
From the Editor
Ten Hours Until Dawn, an outstanding book written by Michael Tougias, chronicles the attempts of the U.S. Coast Guard and a privately owned pilot boat to rescue a foundering tanker off the coast of Massachusetts during the famed Blizzard of 1978. This “winter hurricane” dumped up to four feet of snow in some regions, with winds recorded over 100 miles per hour and wave heights conservatively estimated at 40 feet.
Leveraging secondhand accounts of those who survived, Tougias pieced together archived radio transmissions to postulate what the mariners would have experienced in those harrowing sea conditions.
One thing that stood out to me was that although riding up these huge waves was a tremendous challenge, it was even more dangerous when vessels plummeted down the wave’s back side. At that point, the captain had no control over the vessel, and the boat’s bow would plunge into the trough of the wave, after which the stern could careen over the bow and flip the boat.
It's easy to draw parallels to what balance sheet managers must feel like in the current interest rate environment.
In this month’s Bulletin, DCG Managing Director Zach Zoia urges ALM committees to consider alternative outcomes to the rate forecasts we have been offered by both the Federal Reserve and the markets. He implores committees to “slow down” and understand an institution’s performance in a broad array of interest rate scenarios.
While we are all navigating to the best of our abilities, we need to be prepared for what’s on the other side of this wave of higher interest rates!
“Not so fast, my friend!”
Coach Corso was never convinced that just because every one of his colleagues picked a certain team to win a particular game that it meant he should go along. Right or wrong, he was always willing to challenge the consensus and be open-minded to other possible outcomes.
I think this mindset translates well to managing one’s balance sheet through the most volatile interest rate environment we have seen since the 1980s, one in which even the Fed, as recently as one year ago, was clearly not expecting.
Let’s rewind
Do you remember what the rate environment expectations were late in 2021? Below is the December 2021 Fed Dot Plot, compared to the projections three months earlier in September.
Source: FHN Financial, December 2021
There was an increase in expectations at the December meeting but note that the median dot for the end of 2022 was only 0.875%, and not one member projected the fed funds rate to be above 1.50% at that point.
Even into 2023 and 2024, the rate forecast average was still in the high 1% to low 2% range, with only one member projecting rates above 3%.
The Fed publishes GDP, inflation, and a host of other data projections each quarter in addition to the dot plot. The table below is from their December 2021 meeting.
Source: Federal Reserve Board of Governors, December 2021
Of note, Core PCE was expected to be 2.7% by the end of 2022, and GDP up 4.0%.
Not so fast!
The last time I checked, Core PCE was still running over 6%, and GDP for the first two quarters of 2022 was negative.
I’m picking on the Fed in these examples, partly because they have 400+ PhD-level economists on staff to inform these projections. Nevertheless, in the Fed’s defense, I cannot think of anyone last fall that truly believed we would be in the environment we currently find ourselves in.
Now, if you firmly attached your strategy to the prevailing forecasts of last year, without thinking about Coach Corso’s mantra, how are you feeling about your balance sheet decisions today?
Now let’s fast forward
The chart below shows the evolution of the Fed’s median dot forecast since December 2021. The short-term benchmark rate is now potentially expected to be above 4% by year-end 2022, peaking next year in the 4.50-4.75% range. (For what it is worth, futures markets have the Fed at rates around 5% by the first quarter of 2023.)
Source: The Wall Street Journal, September 2022
For completeness, here is the updated Fed economic projection table from their September 2022 meeting. Expectations include a rising fed funds rate, increasing GDP, increasing unemployment, and declining inflation. I know most understand these are averages and general ranges, but it is an interesting narrative to see if this “soft landing” can actually be pulled off.
Source: Federal Reserve Board of Governors, September 2022
I would be remiss if I did not also include the chart below, which shows that when the Fed embarks on a tightening cycle and the curve inverts (note: the yield curve has been inverted since July when comparing the 2 YR UST vs. the 10YR UST), recessions (i.e., the gray shaded areas) generally follow.
So, given what transpired over the past 12 months (i.e., how wrong consensus views were) and having some understanding of history, how confident are we in these current expectations for the rate and economic environment?
No matter your answer, which I know from my conversations with clients nationwide vary considerably, prudent balance sheet risk managers ought to remember that ALM models should not be designed and interpreted as an exercise in predicting the future.
The point of a model is to understand how an array of plausible – and some “implausible” (we may think) – interest rate scenarios may impact balance sheet performance, and how to strategically manage those potential exposures and benefits moving forward.
Back to basics
When rates and economic data are moving as fast and with as much volatility as 2022 has produced, we often observe groups getting “sped up,” not unlike a young college quarterback who was not expecting a blitz.
The dizzying pace of changes in the rate environment causes many to be influenced by the latest trend or forecast, which can bias strategy.
Don’t let that happen.
When it comes to making decisions based off your interest rate risk models, remember the fundamentals:
Run enough scenarios to effectively triangulate exposures, but not so many that it becomes “paralysis by analysis.”
Minimize speculative viewpoints; not even the Fed can accurately predict what they will do next.
Develop strong model assumptions and an honest assessment of where they could fall short… after all, you are making decisions off them.
Emphasize contingency planning and stress testing, which are not just for “bad” times.
Play “devil’s advocate.” Compel a conversation of “what if we are wrong?” for every strategy considered.
As always, “Listen to your balance sheet.” It is constantly telling you something.
History in the making
2022 has been a historic year from the rate environment perspective, and the game very well may not be over yet. The best ALCOs we see continue to be unflappable amidst the chaos, rely on the fundamentals, and block out the noise of the last forecast cultivated by the Fed, the Street, or their next-door neighbor.
Yet, we fully understand it is not always easy to execute given the pressure of the current environment. And it is inescapable that at some point over the next year, you will have that moment in ALCO when there is a clear consensus of where your group thinks rates are headed, or what strategy is a “no-brainer” to execute.
I implore you to channel your inner Lee Corso and remind everyone to consider alternative views and outcomes. “Not so fast, my friend!”
ABOUT THE AUTHOR
Zach Zoia is a Managing Director at Darling Consulting Group. He helps management teams throughout the country develop strategies to improve financial performance and more efficiently and effectively manage liquidity, capital, and interest rate risks.
Zach began his career with DCG in 2008 as a financial analyst. He earned a B.S. in finance from Boston College and his M.B.A from Babson College.
© 2022 Darling Consulting Group, Inc.
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