Being There - Episode 27
last updated on Tuesday, March 29, 2022 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.
It’s Spring. The yield curve has become the bedraggled byproduct of a tug-of-war between inflationary prospects, geopolitical turmoil and the age-old question of whether or not “in the Spring, there will be growth.” That’s the infamous quote from a 1979 film, “Being There” in which Peter Sellers played simple-minded gardener who had been sheltered all his life, is suddenly left on the street with no knowledge of the outside world apart from the skill of watching television. Through accident, twists and circumstances, the naïve gardener ironically becomes a trusted economic advisor to the President. He is misinterpreted as a wise economics expert as he meticulously describes a gardener’s perspective on the change of seasons.
The world has changed dramatically since late February. Back then, the Federal Reserve, and for that matter, the financial markets were expecting a steady degree of monetary tightening over the next 18 months. With waning COVID cases, strong consumer demand and tightening labor markets, the focus was squarely on inflation containment. Now, there seems to be a little more buzz about past economic cycles that involved the impact of price shocks on economic growth. As a result of geopolitical tensions, commodity and energy price shocks have occurred on top of an already high inflation rate that is at a 40-year high. While consumer balance sheets are presently healthy and employment levels are more than satisfactory, it’s natural to think about a stagflation scenario in which the yield curve flattens, perhaps even in a rising rate environment. That scenario has sometimes been the case during periods of price shocks, at least in my lifetime, such as during the 1970’s oil embargo. During this time, economists taught us that inflation becomes especially concerning during the convergence of “cost-push” and “demand-pull” forces. The former phenomenon is represented by supply disruptions and the latter is represented by strong demand that is perpetuated by too much money chasing too few available goods and services. Ultimately, inflation is thought to serve as a tax or economic depressant.
So, with the yield curve flattening of late, what’s your stagflation scenario for interest rates and credit impact? The Federal Reserve recently released its so-called “CCAR” or Comprehensive Capital Analysis and Review stress test guidelines. While the scenario playbook contained the 2008 replay of rapidly deteriorating credit and capital conditions, another replay may have been overlooked. This scenario, over 40 years old, represented the two-headed conundrum of stagflation. A period of sustained inflation and moribund employment and Internal economic growth, brought on by a Fed whose hand was forced into a particularly impactful rate increase. Given the growing chances of unexpected outcomes and volatility, it’s becoming all the more important to model the impact of a 1979-1982-style scenario – a three-to-five-year time horizon in which rates could rise at a rate greater than anticipated, the yield curve then inverts and deteriorating credit impinges on liquidity and capital.
Just as spring weather conditions can rapidly change, so can interest rate and liquidity risk. All this reminds of Sinatra’s tune “That’s Life.” April’s confidence in asset sensitivity might have you riding high, only to be shot down in May! May 3-4, by the way is the next meeting date for the FOMC. Modeling risk requires knowledge of where your income and balance sheet metrics stand at multiple points on a representative time horizon. It’s useful, as well, to assess where we are in the economic cycle. Clearly, we are in the early stages of monetary tightening. The flattening of the spread between the two-year and ten-year maturities provides a great example. A year ago, the spread exceeded 150 basis points. Now that spread is in the teens.
In the past, when tightening tales place rapidly, credit underwriting also tightens. That phenomenon may or may not occur this time around with excess liquidity and institutions fervently searching for assets. A more gradual rate of tightening which would be more accepting of inflationary pressures has historically been met by a continued positive slope in the yield curve. With the clear flattening of late, it appears that the market is leaning toward a Fed that is concerned about inflation and is likely to push the brakes accordingly. If you’re asking yourself what might happen if the Fed overcorrects, those of you who are asset-sensitive, might also be asking if in may make sense to review your balance sheet strategy over the next phase of the economic cycle. Think about how your balance sheet in the event rates begin to fall. If the script would call for further flattening or even inversion, you may want to consider ways to protect your margins through the cycle’s peak and trough of rates. You may want to consider such moves as funding with shorter duration liabilities and building investing or lending ladders further out on the curve.
The Federal Reserve expectedly threw out the opening pitch with an initial 25-basis point hike in the targeted funds rate. More importantly, the Fed telegraphed rate increases to be put into effect at each of this year’s remaining FOMC meetings. The implied 2%-or-so target rate is double the communicated target of just three months ago. Three more rate hikes are factored in for 2023. Acknowledging that there a tight needle to thread, the forecast for their favorite definition of inflation (personal consumption expenditures ex-food and energy) 2022 inflationary expectations were hiked from last December’s forecast of 2.7% to 4.1%.
Conversely, forecast GDP growth for the balance of 2022 was revised downward from the previous forecast of 4.0% to 2.8%. As we all know, there are a lot of moving pieces: a sluggish labor participation rate vs. record low unemployment rates; supply chain and energy imbalances and consumers with strong balance sheets that are willing to spend with albeit diminishing levels of confidence. A delicate needle, indeed.
There will likely be an ongoing debate the prospects of a 25-basis point versus a 50-basis point hike in the months to come. We haven’t had a singular 50-basis point move since May of 2000 during the Alan Greenspan days. Shock and awe. If and when that happens, beware of yield curve flattening and cross-winds in equity and other financial markets. Beware too, of transitional adjectives, meaning “transitory” to “persistent” to “runaway” as referenced of course to inflation. All I can say about forecasts, whatever the source, is that they are always wrong. Always. Count on it. Model it.
Baseball, a favorite Spring ritual, has been a bit delayed by labor issues. I was so much looking forward to focusing on real and authentic baseball – the minor leagues. Speaking of the minors, I’ve been composing a list of my favorite, lesser-followed, “minor-league” economic indicators that may be helpful in planning your balance sheet strategies. I’ll share just a few with you, apart from my just having had dinner at a restaurant whose original menu prices had been replaced by adhesive hand-written prices.
First, I’d call attention to an “actions speak louder than words” indicator – the actual size of the Federal Reserve balance sheet. After the March FOMC meeting, the Fed commented on the size of its balance sheet, still standing at $8.9 trillion, whose assets consist primarily of treasury and mortgage-backed securities. The Fed stated that it “expects to begin reducing its holdings…at a coming meeting.” Chairman Powell further commented that any reduction could start in May and be the equivalent order of magnitude of a rate hike. In any event, watch the size of the balance sheet. Over the past two years, the Fed has purchased $1.3 billion in mortgages and $3.3 billion in Treasuries. Should the Fed’s balance sheet indeed start reducing in size this summer, it would be logical to expect a rate premium to cover for the volatility associated with markets needing to stand on their own.
Some additional indicators: The ratio of the nation’s personal savings-to-disposable income. It’s been consistently dropping to normal levels, from a high of 33.8% almost two years ago to January’s level of 6.4%. Does this decline portend tempered consumer spending?
We’ve previously discussed another favorite indicator, the “break-even inflation rate.” How has that been doing over the past month? Well, the Federal Reserve of St. Louis’ five-year version has moved up quite a bit from 2.91% as of last month’s podcast, to 3.51% currently.
As for the CME Fed watch tool, it currently assesses a 42% probability of a 50-basis point rate hike during the May FOMC meeting.
Another indicator is S&P Global Market Intelligence’s calibration of the banking industry’s deposit beta levels. This measurement of the relationship between Fed funds rate changes and deposit pricing is forecast to remain low, in spite of our being at the start of a rate tightening cycle. Why? There’s still a lot of excess liquidity in the financial system. This news would, in theory, bode well for asset-sensitive institutions that can reprice their assets at a faster rate than their funding. How low an implied deposit beta is forecast for 2022? Would you believe 6%?! The industry median cumulative beta has been in the mid-20% range over the past two years.
Recognize though, that deposit betas can and do turn on a dime. So, we are all now on ready watch for that first sign of a competitor’s deposit rate hike. Many are looking no further than the online banks to move first. The current backdrop is a classic time in the economic cycle to dust off your Econ 101 textbooks and think about applying marginal cost to your deposit pricing.
You never know when you might be in a competitive environment in which deposit loyalty becomes more transient and you’ll be focusing on preserving exiting funding levels. Your gut will ask “If my competitors are raising rates on their deposits, should I respond in lock step?” Eleanor Roosevelt had a great answer to this question: “You wouldn’t worry so much about what others think of you if you realized how seldom they do.”
At the beginning of a rate tightening cycle, it’s important to develop defensive pricing strategies to avoid paying unnecessarily for deposits that would not have left anyway. Marginal cost of funding is not just about modeling various cannibalization and pricing scenarios. It’s really about a marginal cost culture.
I’d say it’s five basic disciplines that you need to master organizationally.
- Take advantage of segmentation strategies to minimize cannibalization for existing customers.
- Benchmark your marginal cost of funding by using such wholesale funding duration comparables as the FHLB Des Moines advance curve.
- Be data-driven in your pricing decisions. If your decisions are wrong, correct them.
- Don’t cave into “SWAG” and the behavior of crowds.
- Put together a multidisciplinary team when it comes to developing funding pricing strategies. That means, treasury, lending, retail and other pillars of your institution working together.
This Spring we’ll be talking to our members and trade associations about what goes into developing a marginal cost culture. We’ve put together some great discussion materials and any of us would be delighted to present our thoughts to your boards and ALCO’s. Contact me or your Relationship Manager and we can put something on the calendar.
Two final thoughts.
First, there’s another Spring tradition, tax time. This time of year, public funds balances increase. Many members are typically faced with collateralization requirements on behalf of public entities. Although cash and securities positions may be prolific, you may wish to, instead of pledging securities, consider arranging for FHLB Des Moines to issue a standby letter of credit in favor of the public depositor. Why? You can improve your pledged securities and liquidity ratios. Also, you’ll get a bit of a nudge to deploy your capital toward higher-yielding loans instead of lower-yielding securities. Contact your Relationship Manager if we can run a sensitivity analysis of your collateralization choices.
Second, throughout April and May, we will be hosting Regional Member meetings in six locations throughout the district. We’ll feature an interactive discussion with senior management of FHLB Des Moines.
Also, we’re offering a choice of two concomitant core sessions: o “Development and Execution of Balance Sheet Strategies in Today’s Uncertain Environment” – Featuring Scott Hildenbrand, Managing Director and Chief Balance Sheet Strategist of Piper Sandler – Targeted Audience: C-Suite Decision Makers, Board and ALCO Members o “Optimizing Your Collateral and Available Liquidity Position” – Featuring FHLB Des Moines Collateral and Member Solutions teams – Targeted Audience: Individuals Directly Tasked with the Collateral Management, Filing and Reporting Process (e.g. Loan Servicing and Treasury Staff).
Throughout the sessions, we will provide you with actionable steps and tools, leading to liquidity maximization and optimal balance sheet risk mitigation. Contact your Relationship Manager for agenda and registration details, or go to the Event Calendar on our website. There’s an opportunity for many individuals at many levels in your organization to participate!
On that note, “Be There!” Stay well and we’ll see you next time on the FHLB Des Moines Insider Podcast. Thanks for tuning in.
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