Beware: Action Inertia - Episode 11

posted on Tuesday, November 3, 2020 in General

Hello and thank you for joining us for another episode of The Insider, a bi-weekly 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.

Our recently concluded FHLB Des Moines Leadership Summit left some indelible observations.

Noted author Shawn Achor urged us to spend two minutes-a-day to send a note to a friend or associate that we haven’t spoken to or seen in a while. Even in tough times, simple things can lead to fulfillment and happiness.

Federal Reserve Bank of St. Louis President spoke of the desire for a more flexible targeting of average inflation. He also questioned the relevance of using the heretofore accepted measure of inflation, the PCE index, in favor of the Federal Reserve Bank of Dallas’ so-called Trimmed Mean PCE inflation rate as an alternative measure of core inflation in the price index for personal consumption expenditures (PCE). It’s calculated by staff at the Dallas Fed, using data from the Bureau of Economic Analysis (BEA). For reference, as of the end of August, the six-month annual traditional PCE inflation rate as 1.1%, versus the 1.8% level represented by the Trimmed Mean PCE inflation rate.

Mohamed El-Erian offered some fascinating insights on the economy. The chief economic adviser at Allianz, the corporate parent of PIMCO, broadcasted live from Cambridge, England. Among his many roles, Dr. El-Erian also serves as the President of Queens’ College of Cambridge University. Throughout his remarks, he underscored the importance of trust as the foundation for economic systems. He described a root cause of current economic issues as emanating from “human counterparty” risk, a situation in which certain sectors are severely impacted by questions of public health safety. In contrast, the 2008 round of economic malaise was worsened by “financial counterparty” risk, a situation in which institutions failed to trust others’ balance sheets. The common denominator cited was trust; trust in public health, moral authority and personal freedom. Suffice to say, it’s difficult to fulfill all three objectives all at once in the current environment. With that being said, the IMF’s economic growth forecasts for all of 2020 show some dispersion. The US economy is forecast to shrink by 4.3%, whereas the European economy is predicted to slow down by twice that rate, while China’s economy is actually forecast to expand.

Dr. El-Erian further opined that given the magnitude and severity of the economic downturn, the highly accommodative fiscal and monetary policies may be leading to excess risk-taking, market distortions and rapid boosts in the values of certain asset types. As far as his outlook for the next 12 months, he forecast a bit of a slog, not a “V” or “K-shaped” recession, respectively representing respective rapid recovery or uneven sector-dependent recovery scenarios; but rather a “square-root-shaped” economic landscape. That’s a scenario in which an economy dips, anemically recovers and levels off earlier than it should. In this scenario, short-term rates would be lower for longer, deficits and debt levels would increase, followed by an eventual yield curve steepening. More on the steepening yield curve in a minute. Waning government income support could also elevate credit risk for certain economic sectors.

Finally, Dr. El-Erian prescribed several necessary actions for managing in the current environment.

  1. Acting resiliently in terms or managing your workforce as well as your balance sheet.
  2. Operating with a mindset that is on constant watch for new information and for decision-making blind spots. He described the common human affliction of “action inertia.” As an example, he used the analogy of an English-speaking diner not being able to converse with a French-speaking waiter. In frustration, the diner characteristically continues to speak English louder, and with a twinge of a French accent. We subconsciously act in futility knowing full well that our instinctive reactions often fail to yield results. Action alone doesn’t necessarily solve a problem. In a vacuum, action alone has a way of sometimes making matters worse. 
  3. Finally, today’s environment necessitates scenario planning and cognitive diversity; along with recognition that we will need to re-train and re-tweak the way we have all conducted business.

The only thing we regretted about this year’s Leadership Summit was our inability to meet with our members in-person. But, as my favorite basketball coach’s favorite homily goes, “flexibility is the key to stability.”

It’s earnings season. In many sectors, ALLL levels have stabilized. As many members use outside economic forecasting services, the current read is, at least for now, is that some models that may be overestimating actual credit losses. Higher cash positions are still impacting net interest margins. Mortgage originations remain strong, many CRE portfolios are sustaining payoffs and commercial line of credit usage seems to be reducing. Those term deposits that are maturing and continuing to be deployed are either being diverted to duration-certain advances or to non-maturity deposits.

Going into the election, the slope of the yield curve remains somewhat indecisive. However, during the third week of October, longer-term treasuries saw the highest rates since early June. The spread between two-year and 10-year treasuries in the range of 70 basis points of late, has been at its steepest level since June of 2018. Perhaps upward pressure on yields has been due to election-related forecasts for increased government spending and/or inflationary consequences of generous fiscal and monetary aid. Certainly the 800-pound gorilla that’s standing in the way of a steeper curve are the continued purchases of longer-dated securities by the Fed. It’s fair to conclude that forces that would call for steepening would be increased prospects for more fiscal stimulus (likely after the election), increased government borrowings and a stronger-than-expected economic recovery; versus the non-steepening effects of continued poor performance metrics on the virus front.

Given the volume of forbearance and loan modification activity that’s taken place since March, there’s a bit of an air of “kicking the can” to early 2021 in terms of when me might assess a more accurate degree of credit quality erosion. By and large, third quarter loan deferrals have dropped significantly compared with the second quarter. While this development is encouraging, more members have delineated “second round” deferrals, perhaps justifying another round of increases in ALLL.

The clear common denominator in Q3 earnings announcements has been deteriorating net interest margins. The most common reason cited: excess deposit liquidity that have diluted asset yields. Also, lower loan yields are accelerating. Some institutions have been saddled with high-cost term CD’s, which in the current rate environment simply are slow to turn. There is still a lot of those popular one-year CD’s that remain on the books that were originated and priced during Q1 just before rates dropped in line with the pandemic. It’s easy to see why remaining CD’s support historically low betas. Unlike term advances, these CD’s are generally not pre-payable. Moreover, a recent internal analysis of Darling Consulting Group, who presented at a recent FHLB Des Moines webinar, noted that many institutions are reporting MMDA rates that are twice as high as the rates on corresponding equivalent wholesale funding. Now more than ever, it’s time to focus on the marginal cost of your funding. Call on us if we can help you build a framework for improving your marginal cost of funding culture. Regular modeling of marginal cost of deposit funding and involvement of multiple disciplines within your organization are crucial. Members of your treasury, retail, deposit gathering and ALCO teams should all be involved.

Third quarter earnings season is shedding additional light on the housing market. Call it what you will: historically low mortgage rates, unavailable inventory, capital misallocation or a COVID-spurred hunker-down mentality; the housing market is strong. The Case-Schiller National Home Price Index, which conservatively calculates repeat sales on a three-month average as opposed to a monthly basis, rose at an annual rate of 5.7% in August. The supply of homes is being constrained by rising labor and building materials prices as well as availability of land in certain metropolitan areas.

Here are some interesting snippets from the National Association of Realtor’s summary of the September housing market:

Seventy-one percent of homes sold during the month were on the market for less than a month. Inventory is now at 2.7 months, a record low. Existing home sales grew for the fourth consecutive month, and have increased by nearly 21% versus a year ago.

Anyhow, in thinking about the housing market as the weather cools around my house, I’m prompted to do something about the neighbors that are leaving their sprinklers on. It’s annoying and it’s a source of constant irrigation!

Some PSA’s:

In mid-November, we’ll launch another episode of The Insider’s new companion podcast, “On the Record.” We’ll be interviewing Bill Bemis, our Chief Capital Markets Officer. Bill oversees our balance sheet and is charged with product pricing and other financial strategies for the bank. We’ll have an interesting discussion on such topics as how we’re doing with LIBOR transition, ensuring FHLBank System liquidity and running a balance sheet that demands scalability.

We’ll see you next time on the FHLB Des Moines Insider podcast. Stay well, safe, liquid and may you eschew action inertia. Action alone solves nothing. Without thoughtful deliberation, in and of itself, action often makes matters worse! Thanks for tuning in.


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