A Lesson from the Ghost of Tom Petty
Back at the end of 2018, I asked a question of all my clients during the Q4 ALCO meetings: “Which way will rates go next year?" At the time, the market consensus was the Federal Reserve was on hold, and that flattened out the yield curve. To make the poll a little more interesting and memorable, I offered up three Tom Petty songs and asked which best matched their outlook.
“Learning to Fly” suggested the concerns over the trade war that were bogging down growth outlooks would lessen, and the Fed would start raising rates again later in the year.
“The Waiting Is the Hardest Part” was indicative of a market waiting to see how the 2020 election cycle unfolded before rates would break meaningfully.
And “Free Falling” is self-explanatory: rates decline.
The responses seemed to be split 10%-80%-10% respectively among the three songs. While most everyone thought the consensus outlook would hold, “Free Falling” played softly in the background as the year went on. For many, the risk to rates down was evident, but deemed unlikely to materialize.
The moral of the story? Having a rate bias is fine (we all have one), but perhaps managing by what we want to hear versus what we can least afford to unfold, is a lesson we can learn from.
From the Editor
We have had a rising and falling rate environment within the last few years. When rates were rising, balance sheet strategies to protect against falling rates offered great risk/reward (with the opposite occurring as rates fell). Many banks did not execute these strategies due to the assumption (bias) that rates would continue on and not change course.
In this month’s DCG Bulletin, Jeff Reynolds uses classic songs from Tom Petty to remind us that rate bias (we all have them) should not drive balance sheet strategy. What happens if that bias is wrong?
Please continue to send thoughts/questions about this article, as well as potential topics for future articles.
Keith Reagan, Executive Managing Director
This quarter, I have been asking the same question with similar song groupings.
This year (so far) it would be 5%- 70%-25% split in regards to perspective on rates. Few seem to be thinking rates up is likely at all (at least for some time) with more putting a bias on rates down in the face of the virus epidemic and impact it is having on global GDP.
So while not many “hear” rates up, the question is, “What if they do go up?” Remember, we are currently living the rate scenario many felt least likely just a year ago. What might happen if this current bias shifts suddenly?
The Last Rising Rate Cycle
Rising rate cycles are all a little different. To recap this last one, we saw the FOMC take rates up from 0.25% to 2.50% on their target rate. To simplify, it was rates up 200bps over 24 months. On the deposit side, there was not a lot of push on pricing in the first half of the cycle. But in the second half of the cycle, it was a different story.
Through our Deposits360°® analytics platform at DCG (which affords us a granular view at deposit behavior across hundreds of financial institutions), we see the cost of new deposits increased almost lockstep with the FOMC in 2018. We suspect that rates had finally moved to a level where the difference between 0% and current rates had risen to a point where depositors were more “awake,” and we also think that many institutions had finally hit a stage on liquidity metrics where they had to make a stand on deposit gathering.
On the lending side of the business, pricing moved slowly. Origination rates lagged market indices and spreads to comparable term indices compressed. But as funding costs picked up in 2018, loan pricing improved.
Current Falling Rate Cycle
While this virus is changing the dynamics by the day, the market had been signaling that it is at (or near) the bottom of this rate cycle, which for all intents and purposes can be called -100bps over 12 months.
And boy is loan pricing feeling it. CRE term pricing appears off 100bps from a year ago in many markets, and once again borrowers are clamoring to lock in rates at 4% (or less) for 7-10+ years. This is causing a wave of refinancing that is pushing out larger blocks of assets on the maturity curve, limiting the asset yield lift we might have otherwise expected if rates were to rise a year or so down the road.
Meanwhile, deposit promotions are keeping competitive rates up between 1.50% and 2.00%. This makes it difficult to justify growing if loan rates (forget investment yields) are sub 4.00%. Further, many institutions have to contend with a double whammy of lower-cost seasoned deposit accounts. Currently, there is not a lot of room on average to drop those costs, and if the market rate bias were to change to “up” in the next year or so, many suspect initial lag in pricing pressure that existed in the last rising rate cycle would not be nearly as great. Said in another way: the cost of funds may be a lot more rising-rate sensitive next time around.
While the likelihood of rates up this year seems remote, can your balance sheet withstand it if it happened? What if it rolls through at these rate levels for another year? More assets roll out the maturity curve, and more rising-rate deposit pressure might accrue. How much more pain would rising rates then present, and does it prompt you to head it off sooner versus later?
Amid the virus concerns, it presents a very uncomfortable situation where many rising-rate preparation strategies can weaken a balance sheet in the face of falling rates. What to do, aside from loading up on hand sanitizer and Lysol?
Before taking action, make sure the model you use to benchmark interest rate risk is giving you a reasonable look at what happens to NII if rates change. Do your projections for rates down 100bps a year ago resemble your current rate environment results now? If not, is the reasoning logical? If not logical, are you properly assessing risk? This is a great opportunity to backtest and make sure your model is properly calibrated to reality.
Have you tested to see if another loan pricing lag (or lack thereof on the deposit side) materially changes your comfort level with a rising rate environment? And while prudent risk management guidance calls for benchmarking risk on a “static balance sheet” with no growth or change in mix, does your growth plan over the next year help or worsen your risk profile?
Running what-if scenarios like this is not always easy, but doing this can provide valuable insights into actions you might consider to get ahead of risk before it materializes.
Managing Through Uncertainty
Regardless of your risk posture, there are always things that can be done to better manage it. Here are a few considerations to help begin your discussion at your ALCO table:
Falling Rates: Falling rate hedge strategies to protect against a further drop in rates from current levels are costly. They likely require more than 50bps of Fed easing before that strategy cost would “pay off,” because the market is already anticipating the FOMC will cut 25-50bps in the not too distant future. Will they? Never say never. “You Got Lucky” (to invoke another Tom Petty song) is not a good strategy for managing balance sheet risk.
Fixed coupon bonds funded short might not throw off a lot of spread, but it is likely still at a positive carry that would widen if rates fall. If you have strong capital that you can leverage, it might be a viable on-balance sheet hedge option vs. swapping floating-rate assets to fixed at a current cost out of the shoot. Further, those bonds would appreciate in value if rates fall, which might come in handy if loan losses pick up in a weaker economy.
Out of the money floors on floating-rate assets might also be worthy of consideration to mitigate a protracted low rate environment, without materially changing your rising rate posture.
Rising Rates: If exposed to rising rates, you have some great options to consider to reduce risk. Swapping fixed-rate loans to floating can reduce risk AND add 25-50bps of current spread, though one has to recognize that the market is expecting the FOMC to cut rates and take some of that spread back in short order. Bullet wholesale funding extension has a similar effect. Murphy’s Law states that doing this, though, would guarantee rates will go down, and the risk position should be tested more thoroughly before extending funding. Make sure that hedge strategies against rising rates are not overly problematic for earnings if rates fall.
Interest rate caps on short-term wholesale funding that protect against rising rates are pretty cheap by historical standards, and would still allow you to ride wholesale funding costs down if market rates fall. While the accounting and execution of cap strategies can be a little more involved than swaps, they offer the protection against the rate scenario you want to hedge with a known upfront cost. As such, they are worthy of consideration for liability-sensitive balance sheets.
Unlike the car radio where we can change the channel to find a song we like better, we have to play out the rate environment to the end and then listen to the next “economic song” that comes up. If we do our job right as risk managers, we know what music our balance sheets prefer and what music makes the ride miserable.
Once we understand that, we have volume dials we can use to turn down the noise to a more manageable level if the wrong song (or rate environment) comes on. Make sure you know what they are, how they work, and importantly, be proactive in getting ahead of a bad song that could ruin your ride.
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ABOUT THE AUTHOR
Jeff Reynolds is a Managing Director at Darling Consulting Group. Jeff’s primary responsibility is advising clients on ways to enhance earnings while more effectively managing their risk positions. He regularly assists clients with strategic and capital planning projects and has also served on numerous due diligence teams for client acquisitions.
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