The Evergrande State - Episode 22
last updated on Monday, September 27, 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.
Amid historically high equity and fixed income price levels, we’ve all been on an extended look-out for the proverbial black swan. In retrospect, we couldn’t have many this stuff up – a global pandemic, massive global expansion of the supply of money, and then, recently, some potential “smoke under the hood” in the form disquieting developments at Evergrande, China’s second-largest real estate developer.
Evergrande, with indebtedness of over $300 billion (to provide perspective, about two-percent of the Chinese economy), owns not just over 1,300 commercial and residential properties across almost 300 cities throughout China; but also the Guangzhou Football Club, one of the largest Chinese professional sports teams, money management services, consumer goods and electric cars.
Now, the effort to service the debt with a fire sale of assets is under way. The collateral damage, figuratively and literally, has already been felt: edgier global financial markets, unpaid suppliers and correspondent banks, and a looming obstacle for the growth prospects for the world’s second largest economy.
Possibly next on the horizon: an accelerating credit crunch, a too-big-to fail style government bailout, reduced Chinese purchases of U.S. treasuries. The by-products of Evergrande are not certain and neither are the financial markets.
Not that we like to vent about uncertainties, but here’s a small inventory:
- Although market consensus has the Fed raising rates not until 2023, we’re waiting for more guidance on changes in the Fed’s purchases of treasuries and mortgage-backeds, not just the volume of potential tapering from current $120 billion monthly purchase activity, but also any change in the proportionality of mortgage vs Treasury purchases.
- The labor markets. With the huge miss on the August employment situation report, all eyes will be on September’s. Another miss could warrant a delay in any tapering.
With current forecasts calling for the Fed to start tapering within the next few months and with no articulated change in short-term rates until 2023, it’s rational to consider possible steepening in the yield curve. As of this podcast, the 10-year is trading at a spread of 1.08 over the two-year. That spread has narrowed by roughly 50 basis points since the end of March. That’s put further pressure on margins for our predominately asset-sensitive membership.
Fundamentally a flatter curve could be ascribed to a flight-to-quality reaction in the wake of such variables as Evergrande or pehaps the Delta variant’s economic impact, while a steeper curve could be associated with the sentiment that the current bout of inflation is something other than transitory and that tapering will result in a higher supply of securities that will hit the market.
During the start of 2021, we noted that 10-year Treasuries had sported a handle well above 1.00 percent for the first time since March of 2020. After peaking at 1.75% this past March. We’ve settled into the 1.30’s. We find this interesting, as earlier in the year, inflation estimates were a bit lower than they are today.
For the three months from May through July, the trimmed mean personal consumption expenditure inflation rate, a favorite Fed metric has been a mere 1.98%, a far cry from the annualized, seasonally adjusted Consumer Price Index readings of 6.9% over the past four months.
Remember that the PCE records how much individuals actually consume. The CPI uses data from household surveys; while the PCE uses data from the gross domestic product report and from suppliers. Because of these reporting divergences, CPI frequently exceeds reported PCE. Clear as mud, right? In any event, recent PCE levels are roughly 50 basis points higher than they were a year ago.
Remember that proxy, or perhaps a “point spread” for inflationary expectations that we discussed in a podcast back in the spring? Let’s calibrate the difference between Treasury Inflation Protected Bonds (“TIPS”) versus their counterpart Treasury yields. Well, the answer is, surprise; the spread has also increased by roughly 50 basis points since the first of the year.
This spread, known as the “break-even” inflation rate, implies that if actual inflation is higher than the break-even rate, in this case, currently 2.50 percent, an investor would be better off owning these inflation-adjusted Treasuries than they would be in the case of standard 5-year Treasuries.
So, what does this all mean for a balance sheet manager? A recent upward shift in inflationary expectations, taper talk and apparent reticence by the Fed to hold short term rates for at least another year, should prompt a focused assessment of so-called “bear-steepener” yield curve scenarios.
While many an asset-sensitive institution may celebrate some potential relief from margin pressure under this scenario, beware and ask yourself the question, “Am I as asset-sensitive as I think I am?” Maybe as a counter to margin pressure, you’ve been investing further out on the yield curve and your assets don’t reprice the way they used to. Maybe those excess deposits aren’t as long in duration as a funding source as they once were.
Think about it. Markets seem to be expecting inflation to exceed 2.50% over the next few years, so consider three and five-year advance rates as a benchmark. Adjusting for a 6% cash dividend rate, these levels of late, have approximated 50 and 90 basis points, respectively.
So, advances are being priced through inflation (at least by using an inflation proxy of 2.50%) by a wide margin; meaning that members may effectively borrow at negative expected real interest rates. Now could be an opportune time to lock in funding at expected negative real yields!
While we’re on the subject interest rate opportunities and challenges, let’s briefly discuss another omnipresent source of recent margin contraction, excess liquidity.
I’ll share some symptoms of excess liquidity from the industry’s second quarter’s results. Let start with credit unions. Compared with the second quarter of 2020, the NCUA noted: a 15% increase in shares and deposits, a drop in the aggregate net worth ratio of 30 basis points, net interest margin dropping from 2.88% to 2.57%, a 24% increase in cash balances and a decline in loans-to-shares from 76.3% to 69.6%. Want more evidence from the banking industry:
A similar drop in net interest margins from 2.81% to 2.50%. A record low loan-to-deposit ratio from 63.4% to 56.9%. A 10% increase in deposits. However, equity ratios were largely unchanged. And with that my elevator analysis is over!
So, excess liquidity has not just resulted in margin compression, it’s also pressuring loan-to-deposit, and to some extent, leverage ratios. Recognizing that financial institutions will no longer enjoy the benefits of PPP loan originations as well as reversals on loan loss reserves, there will be all the more pressure to book quality loans.
While we’ve seen institutions somewhat cautiously increasing their mortgage holdings (by cautiously, I mean being mindful of possible Fed tapering of MBS purchases) and extending asset durations while funding short; we’ve also seen more institutions developing innovative product line extensions for their loan products.
Some examples: Marketing home office loans as a specific niche product. Creating unique lending programs such as fully-amortizing 10-year mortgages that are designed for those 50-somethings desirous of a debt free retirement. To many consumers, a forced savings surely beats the close-to-zero investment returns available in the current rate environment.
Even though excess cash could gradually wind down in the wake of unemployment programs waning in addition to less aggressive Fed buying of securities, the effects of excess liquidity caused by increased the money supply, quantitative easing and massive fiscal stimulus, (think infrastructure bill, will be here for some time).
Now is a good time to look at your deposits straight in the eye and question their duration prospects. Are they stickier than you had originally thought? Longer deposit durations increase your asset sensitivity. Is this where you want to go in the event of a flat yield curve? Think about diversifying your funding base. If you’re concerned that your deposit durations are growing, you might want to consider diversifying that funding base with shorter-term advances.
With the end of the year on the horizon, members will need to be prepared for the fact that no new Libor-based contracts will be permitted to be issued. LIBOR-indexed loans originated after 12/31/21 will not be eligible for pledging as collateral. By June 30 of next year, LIBOR loans pledged as collateral will be required to include acceptable fallback language if the maturity is beyond the LIBOR cessation date as of June 30, 2023.
The same would apply to LIBOR-indexed securities by December 31 of 2022. Then, finally, by June 30, 2023, FHLB Des Moines will not accept any securities or loans indexed to LIBOR as pledged collateral. Sounds “liborious” but watch the calendar! Right about now is when you should be amending any LIBOR-based loans that do not have adequate fallback language.
All of this talk lately of “black swan” events such as excess liquidity, debt ceiling uncertainty and Evergrande is prompting me to tell the ancient story of the agitated boss exclaiming to an employee, “You missed work yesterday, didn’t you?” Tersely, the employee replied, “No, not particularly!”
Stay well and we’ll see you next time on the FHLB Des Moines Insider Podcast. Innovatively and prudently grow your loan portfolios. Diversify your funding. Price intelligently. And when it comes to those inevitable black swans, “never turn your back on the sea.” Thanks for tuning in.
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