NIRP, PIRP or ZIRP? - Episode 9

posted on Tuesday, October 6, 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 recent scan of the Federal Reserve’s H.8 report shows a banking system whose deposits have increased at an annualized rate of 16.0% since July, compared to an annualized decrease in loans of 6.4% that has been accelerating due to the absence of PPP originations. It’s become clear that rather than deposit proceeds going into loans, they are being directed into rising cash balances and securities. We’ll discuss observations on what the yield curve is implying for investing and funding in a minute.

Hinting at where some of the financial system’s excess liquidity has been deployed, the Federal Housing Finance Agency reported an increase in its Home Price Index for July as increasing 6.5% year-over-year. Increases were particularly pronounced in Pacific and Mountain states. The past two months have represented the largest two-month increase in the index since its inception in 1991. Low interest rates and low inventory appear to be additional drivers.

In our last episode, “Unintended Consequences,” we spoke about the Federal Reserve’s recent rate guidance and its increasing acceptance of inflation, which may even be tolerable, at least in the short-term without accelerated economic or employment growth. The advice was to not give up on modeling a steeper yield curve’s impact on NIM and MVE/EVE. By the same token, it’s not completely out of the question to consider absolute negative rates, a concept that was once thought of as strictly hypothetical. In fact, negative interest rates, in practice, have had a long history, some of which were prompted by situations that are mirror images of today’s circumstances.

As a student in the mid-1970’s I remember tales of global capital rushing into Swiss Franc-denominated deposits in the midst of unglued world markets. In a move to discourage a sudden strengthening of the Franc and discourage excess liquidity and currency appreciation, the Swiss Central Bank imposed negative interest rates to the tune of negative 12% for non-resident deposit accounts. The result was an almost complete breakdown of the export sector and an ensuing recession, followed by rampant inflation by the late ‘70’s.

So, let’s ponder for a minute over negative interest rates. No doubt, a NIRP environment would be the dystopian scenario for the vast majority of financial institutions.

Protracted negative rates imply expectations that prices of goods and services would continue to depreciate. Not only did negative rates exist in Switzerland in the ‘70’s, but they also exist today in the form of policies of central banks in Japan and Europe, for some time and throughout the yield curve.

From the viewpoint of an investor, then, negative rates imply no limit on potential price appreciation. Currently, in the U.S., it’s thought that negative rates would run counter to Federal Reserve desire to not reinforce depreciation psychology. They’ve been dismissed as a monetary policy tool.

There are other deterrents to negative rates. For one, information systems. It may be some time before software programmers, including mortgage servicers, agencies and other financial intermediaries could keep up. Think also about the practical aspects of living with negative rates.

Conceivably, one’s mortgage balance could even decrease faster than one’s monthly payment! Now, on the surface that’s an odd way to increase housing affordability. Although servicing costs and risk premiums would inhibit mortgage rates going negative should treasury yields go negative, negative rate mortgages actually are actually today commonplace in Germany and Scandinavian countries.

When we’re assuming that negative rates won’t transpire, we’re assuming a concept called asymmetrical risk. Under this condition, risk can produce returns (or negative returns) that can surpass the risk taken. How so with the assumption of no negative rates? Think of it this way, from an investor’s viewpoint. If we’re assuming that rates can’t go below zero, gains on fixed income investments are essentially capped, although losses (in the event rates increase) are not at all capped.

As an example, in the event the 10-year treasury were to drop from its current level of 70 basis points, to zero, it would generate a return of 7%-or-so and that would be the return cap, whereas if rates were to rise to say, 2.50%, the resulting negative rate of return would approximate 16%. In theory, the possible downside is infinite relative to the upside, assuming a rate floor of zero.

So what would the logic of asymmetrical risk imply? Investors would understandably see risk weighted toward the downside under the current rate environment and would tend to avoid longer durations. Conversely, borrowers would intuitively want to shun shorter durations.

The implied forward yield curve serves as a good picture of the so-called “point spread,” or what borrowers and investors are collectively projecting for interest rates.

What does it currently suggest? Our review of the implied yield curve shows that, throughout the yield curve, from an investor’s perspective, there is negligible so-called “roll-down” benefit. What do we mean by this?

As an example, consider the case of an investor that is thinking about investing in a one-year fixed income security versus a two-year security. We’ll ask the question, “At what point would you be better off purchasing the two-year security and selling it at the end of the first year, versus purchasing a one-year security?”

That is, should rates rise, even though some principal loss could occur with the longer-duration security, would the extra yield earned on that security more than offset the loss? Our break-even analysis model suggests that the answer is ‘no’.

Of late, there’s only been roughly ten basis points of protection from rising rates. An investor would have only made the right decision to invest in the two-year security if rates wouldn’t rise by more than ten basis points during the one-year period. In and of itself, that’s not a real good reason to invest long.

Conversely, for borrowers, the implied forward yield curve analysis, again, all other considerations aside, would suggest funding with longer durations. Again, we’re looking at simply the yield curve’s so-called “point spread” and your own institution’s unique balance sheet rate sensitivity should remain an important consideration.

There are many reasons not to make investment or funding calls simply because of what the implied yield curve says. As an example, in today’s environment, some institutions, if faced with credit stress, may prefer to fund short in order to have flexibility to shrink their balance sheets. Implied forward rates are gauges that you should keep an eye over as a tool to help you do what’s right for your own balance sheet.

Make it a habit to use a “break-even” analysis of the yield curve as an occasional review of the “point spread.” It can often be a good barometer of what an efficient market is telling you about how you might position your balance sheet. Let your Relationship Manager know if we can help you explore this analysis further. It’s a useful ALCO tool.

Just as we suggested in our last podcast that you shouldn’t give up on modeling a steepening yield curve, the same might apply to a negative rate scenario. Be prepared for unlikelihoods, or as in the ancient homily originally ascribed to Benjamin Franklin, “By failing to prepare, you are preparing to fail.”

In the meantime, we’re likely to see our investments comprise a larger share of our balance sheets. With muni’s, the risks involve likely increasing supply and strained budgets, although the possibility of future tax hikes could improve their position.

With mortgage-backeds, prepayment speeds are increasing, although shorter and more structured-tranche CMO’s could increase predictability of cash flows. While yields are dropping and prepayment speeds are accelerating (it’s shocking to see short durations of 15 and 30-year mortgage-backeds these days), it seems that virtually all investment alternatives require so-called CUSIP-driven analysis, looking for those high FICO’s and low LTV’s.

Some PSA’s

This week, in association with Matt Pieniazek and Mark Haberland of Darling Consulting Group, we hosted a 90-minute webinar on the state of current liquidity.

We discussed how best to maneuver in an environment wrought with excess liquidity, including deposit pricing and investment deployment.

There were some interesting nuggets to consider, including not being shy about inverting term deposit funding, if warranted in an inelastic rate market; or considering the origination and holding of 10-15-year mortgages, particularly those with higher FICO’s and lower LTV’s.

You can access a recording of the webinar on the Educational Resources section of our website.

Registration is still open for our 2020 Virtual Leadership Summit on October 21. Join us with our special guests, including Mohamed El-Erien, Chief Economic Advisor at Allianz and PIMCO along with James Bullard, President of the St. Louis Federal Reserve Bank. Also presenting will be Shawn Achor is a world-class author, and speaker known for his advocacy of positive psychology. Perfect for the current rate environment!

We’ll also have some interesting extras that will keep you engaged throughout the afternoon.

Finally, what do Community Colleges of Spokane Foundation, David Street Station, St. Louis Builds Credit, L.I.F.E. Team Expo, Herreid Area Housing Development Project, Bowling Green Downtown Revitalization and the Gowrie Grocery; have in common? The answer: reason for congratulations. From Missouri to Guam, they represent finalists for this year’s Strong Communities Award. From October 5 through 9, the program is in the public voting stage. Cast your vote and find out more on our website.

A last call. Our special COVID-relief special advance program expires on October 15. Three and six–month maturities are available at highly competitive levels. Call the Money Desk for more information.

Finally, tune into The Insider’s new companion podcast, “On the Record.” Early this month, we’ll be interviewing Wil Osborn, our newly-appointed Chief Business Officer. Wil will provide some interesting insights on the FHLBank System and what it takes to optimize the performance of the cooperative and best serve our members.

We’ll see you next time on the FHLB Des Moines Insider Podcast. Remember to tap into the Liquidity Webinar that we recorded on September 29 with Darling Consulting Group by accessing our Educational Resources webpage.

Stay well, safe, liquid and may you remain on the profitable side of asymmetrical risk! We’ll talk about how to add symmetry in an asymmetrical world and help you level the playing field next time on The Insider podcast. Thanks for tuning in.


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