The Cup of Pythagoras - Episode 19

last updated on Tuesday, July 6, 2021 in General

Hello and thank you for joining us for another episode of “The Insider”, a monthly podcast production of the Federal Home Loan Bank of Des Moines and your source for industry news, strategies and key information about the bank. This is your host, John Biestman, Senior Relationship Manager.

There is an ancient Greek riddle whose modern version goes something like this: “What is the common thread of the acts of eating good food and scratching one’s back?” The answer: “Once the action starts, it is difficult to stop.” Perhaps a skeptic would add the act of adding to the Federal Reserve balance sheet and expansive monetary policy to the list!

Again, turning to the wisdom of the Ancient Greeks, Pythagoras engineered an everyday object that demonstrated the necessary physical and moral regulation of excess, in favor of moderation. The Cup of Pythagoras was perhaps originally intended as a practical joke, with the object being to pour a reasonable and moderate amount of liquidity into the vessel. Above a certain line, about three-quarters below the lip, is a representative boundary between moderation and excess. Once the amount of liquidity fills above the line, the entire contents of the cup immediately vanish. If you’d like some advice on where to purchase this work of ancient engineering and morality, feel free to contact me or your Relationship Manager!

One can’t help but wonder how the Cup of Pythagoras might represent today’s financial environment. The concepts that the cup represent are of course moderation and balance. That is, there could be consequences of too much liquidity, or too much of what seems to be a good thing. If ancient thinkers were to critique today’s monetary policy, they might debate the proper positioning of the line of moderation as well as the visible consequences of excess liquidity; among them: rising inflation as represented by the May PCE index ex-food and energy of 3.4% annualized, the largest monthly gain in 30 years; and producer prices that climbed to an all-time record of 6.6%. Still, financial markets have not yet appeared to be overly concerned. As Chris Low, FHN’s Chief Economist who presented during our recent Member Value Meeting and others are asserting, we are now seeing expected transitory labor shortages and supply bottlenecks that are characteristic of switching back on from a COVID economy, which a year ago was operating at a dramatically reduced base. But the harsh reality is that prices of multiple goods, services and assets (think housing and equities) are climbing. By the way, the latest Case-Shiller National Housing Price Index registered a 14.6% annual rate of increase (just like the heat records recently broken in the West recently) the highest level since records have been kept. Recognizing that inflation is part-psychological (prompted by consumers and producers believing that prices will continue to rise) and a case of too much money chasing too few goods, services and assets; there’s understandable concern that the Fed is operating close to that line of moderation in the Cup of Pythagoras. Discussions have already begun on the degree to which the Fed’s $120 billion monthly securities purchases might be tapered, but still, there’s not yet been a sharp market reaction a la the 2013 taper tantrum when the mere mention of the possibility of paring purchases caused rates to rise and fixed income investments to plummet. 

Remember that in recent months the Fed has been on record as accepting inflation exceeding two percent if the economy has not yet sustained full employment…Which further muddies the waters when we know that labor shortages and pent-up consumer and capital spending are now being added to the mix. Notwithstanding all the superlative headlines regarding inflation, just maybe the Fed is focusing on the labor situation. Here, the numbers show the disruptive impact of the COVID economy. Eight million workers have been purged from the payrolls, while nine million job requisitions remain unfilled.

So, what to do in this environment of asymmetrical interest rate risk, margin pressure and excess liquidity? Put the cash to work and get it out the door! Easier said than done with the industry loan-to-deposit ratio now standing at 61%, the lowest since the energy shock recession of 1973 when the Federal Reserve first started keeping records. As many members are asset-sensitive, among the more popular strategies of late include: portfolioing fixed rate mortgages, pre-funding pending investment maturities, extending asset durations and funding short. What do we see the neutral or liability-sensitive members doing? Well, many are “blending-and-extending” their existing advance funding. 

Recognizing that uncertainty of interest rates is heightened of late, it’s useful to think about specific defensive funding strategies. We’ve updated a few of these on our website. Look for “Funding Strategies to Protect Yourself Against Interest Rate Risk.” We cite a few examples:

• For members that are looking to retain mortgages, we highlight the benefits of blending long-term fixed-rate advances and deposits. Using a mix of advances and internal deposits can, despite historically low mortgage rates, still attain spreads in excess of 200 basis points alongside rising interest rate protection that can be further enhanced by using symmetrical and forward start advance structures. 
• For commercial real estate funding, amortizing advance structures are a great way to custom-match multiple amortization loan terms.
• For those members that hold auto loans, blended and laddered amortization structures can help fund auto pipelines at dividend-adjusted rates below one percent on terms inside of seven years. The yield curve has steepened over the past few months and advance rates in intermediate maturities are attractive. 

Remember that advance funding, at the margin and with the dividend, is your lowest cost alternative. Its duration-certain characteristics are a necessary complement to duration-uncertain deposits. With advance funding, members control the terms. So, again, check out some of these funding examples. More importantly, call on your Relationship Manager and our Member Strategies team to customize blended funding situation that are right for your organization. We’ll roll up our sleeves.

As far as the funding markets themselves are concerned, the Fed is now starting to withdraw the mechanisms put in place during the first quarter of last year including the PPP Liquidity Facility and the Secondary Market Corporate Credit Facility. “Taper talk” could accelerate as the year progresses. 

At the time of this podcast, on a dividend-adjusted basis, all-in posted advance rates were eight basis points six months-and-in. That includes the overnights. But it gets even better. We still have a special rate that is running until July 16 in the three-month and six-month maturities with dividend-adjusted levels at five and four basis points, respectively. Think of the arbitrage opportunities, as investment rates and returns are still positive!

There’s no doubt that everyone tuning into this podcast remembers the Pythagorean Theorem from grade school; you know, the one that states that in a right-angled triangle, the square of the hypotenuse equals the sum of the squares of the two adjacent sides. I don’t know about you, but back then as well as now, I’ve always wondered what “a-squared + b-squared = c-squared” has to do with anything in our daily lives. Well, it turns out that one of the direct applications of the theorem is navigation, where if given two lengths, you can make life easier and find the shortest distance. The same concept would apply to how FHLBDM’s off-the-shelf duration-certain, low cost advances can help you manage your balance sheet. Many members today are holding excess cash. Think of the Cup of Pythagoras. If you are in an excess cash position, you are doing nothing more than eroding your future earnings. Why hold excess cash when you have plenty of funds available to borrow from FHLB Des Moines? Even now, if you’re not in a net borrowing position, you’re eroding future earnings and the value of your enterprise.

Stay well and we’ll see you next time on the FHLB Insider Podcast. Thanks for tuning in.

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