Unintended Consequences - Episode 8
last updated on Tuesday, September 22, 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.
In 1691, the English Parliament held hearings on a bill that proposed to lower the arbitrary fixed rate of interest target from 6% to 4%. John Locke, a major figure of the Age of Enlightenment, wrote a letter to Parliament that cited the dangers associated with the proposed reduced interest rate target. Locke, known in philosophy circles as the first individual to popularize the phrase, “law of unintended consequences,” cautioned against the potential destructive effects of the proposal, citing “detrimental impact on the savings of widows and orphans, increased advantage for specialist bankers, brokers and merchants, money hived offshore, and perjury.” Sounds like an ancient fear of market dislocations to me!
On our last podcast, we talked about the Federal Reserve's update to its Statement on Longer-Run Goals and Monetary Policy Strategy. As we know, the revised guidance implied that the Fed would hold off on monetary tightening in the event inflation increased beyond its previously stated threshold of 2%. Thus, far, it's been quite a while since we've not fallen short of this goal. Remember, that the two-percent figure is based on the Fed's preferred measure of inflation, the PCE deflator.
Notwithstanding the fact that monthly CPI and PPI numbers on an annualized basis have been running above two-percent annualized of late, it's interesting to consider the potential unintended consequences of generous fiscal and monetary policy on capital allocation.
On September 16, the Fed guided that rates would not increase for the next several years. Not present in the guidance was a further commitment to purchase securities.
Automatically, this lack of mention might make one wonder about implications for any prospective steepening of the yield curve. In the coming months, we may be thinking more about massive intervention as a possible root cause of future asset inflation, not necessarily reflected in the PCE index.
Perhaps the near non-existent yields on short-term fixed income investments has prompted sizable allocations into homes in the suburbs with room for home offices, lumber and other commodity prices and, casting aside recent down days, a stock market at or near its historic highs.
Note lumber prices. They've skyrocketed from $250 per thousand board feet, to now almost $1,000. We shall see if rising building materials costs will impact housing demand, or at the very least the average square footage of a new home.
The housing sector is clearly being bolstered by low-interest rates, urban exodus and millennial generation-related demand. The National Association of Realtors reported that the nation's median U.S. home price crossed the $300,000 line in July, along with annualized sales of 1.5 million units.
The current 67.9% homeownership rate that was recorded by the Commerce Department during the second quarter is now at the highest level since the fourth quarter of 2008. During the last recession, the ownership rate had dropped to 63.4%. According to the Mortgage Bankers Association, things aren't as bright on the delinquency side. As of June 30, we were at a nine-year high, with roughly 4.2 million mortgages in forbearance. We'll see if the continued lack of a new stimulus bill and fiscal assistance exacerbates the trend.
While stock and housing valuations appear frothy, the same adjective would not currently apply to such other capital destinations such as small businesses and consumers, many of which have been burdened by expiring government relief funds, an uncertain duration of the pandemic and stagnant spending.
The situation makes you wonder if the Fed's ability to adjust the old Philips Curve, or dual mandate model of balancing inflation and unemployment is tenable any longer.
Over time, it may be prudent for ALCO's to assess the possibility of inflation existing without accelerated economic or employment growth under the new Fed framework.
Don't necessarily give up on modeling steepening yield curve scenarios as an unintended consequence! It's not necessarily about making a rate call, but it certainly is about gaining some understanding about the impact of multiple rate and yield curve scenarios to your NIM and MVE/EVE.
What a better segue than to bring up a balance sheet strategy coined “beat the spread.” This is a balance sheet strategy that is used by some members in search of competitive term funding. It involves entering into a pay-fixed/receive floating rate interest rate swap.
The idea is to take down a shorter-term FHLB Des Moines advance, say three months, that matches the effective date of the swap. In turn, the swap is typically designated as a cash flow hedge against any changes in advance re-pricing. For the term of the swap, short-term advances would be rolled at the same frequency as the matching swap re-set dates. The mechanics require some accounting examination in the area of effectiveness testing in order to support that the hedging relationship is highly effective.
When you combine a long-term plain vanilla fixed rate swap with rolling short-term FHLB Des Moines advances, you very well may be able to lock in funding that would be below typical term advance rates.
You will best “beat the spread” when the long-end of the swap curve is well below that of the advance curve. You'll also want to be mindful and work with your accounting team regarding the proper treatment of short-term advance rates paralleling the floating rate that will be received from the underlying interest rate swap.
So, if you're looking at term funding as a balance sheet management tool, speak to your Relationship Manager for more information on the “beat the spread” strategy, where you can use an interest rate swap and simultaneously roll short-term advances for the duration of the swap, resulting in competitive net fixed rate term levels.
Some PSA's
Next Tuesday, on September 29, in association with Matt Pieniazek and Mark Haberland of Darling Consulting Group, we will be hosting a 90-minute webinar on the state of current liquidity, let's call it the liquidity crisis in reverse (that is, too much liquidity). There will be some interesting discussions on such topics as: optimally deploying excess liquidity into working assets, current thoughts on stress testing and something that we've touched on in recent podcasts, the benefits of diversifying funding sources. Start time will be 3:00 CDT/1:00 PDT and you can register on our website.
Registration is also open for our 2020 Virtual Leadership Summit on October 21. Join us with our special guests, including Mohamed El-Erien, Chief Economic Advisor at Alliance and PIMCO along with James Bullard, President of the St. Louis Federal Reserve Bank, and much more.
Look soon for an announcement on the final selections for this year's Strong Communities Award. We had a record amount of submittals this year in the urban and rural categories with many presentations of innovative and impactful ideas and programs. Public voting will take place on the finalists from October 5 through 9. Look for further details on our website.
October 1 will bring in a new round of Home$tart funding. We'll have an additional $2 million in funds available for eligible households to receive up to $7,500 in down payment and closing cost assistance.
It's going to be a busy fall.
An additional note: Our special COVID-relief special advance program expires on October 15. We still have funds available in three and six month maturities that, of late, have been offered at rates between 10 and 11 basis points below regularly posted levels, and that's not even including further net reductions resulting from incorporating the cash dividend on associated FHLB Des Moines activity-based stock. Cumulative draws under this program limited to $60 million per member institution. Also, for this specific program, you'll need to call these orders in to the Money Desk, as opposed to executing online.
There's also something new on the podcast front. In addition to the FHLB Des Moines Insider podcast that you're currently listening to, we are going to start a new podcast track called “On the Record.” These monthly podcasts will consist of interviews with FHLB Des moines specialists as well as outside subject experts in such areas as capital markets, economics, balance sheet management and more. We'll be kicking off “On the Record” with a conversation with Wil Osborn, FHLB Des Moines 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.
We'll see you next time on the FHLB Des Moines Insider Podcast. Remember to register for our Liquidity Webinar on September 29. Stay well, safe, liquid and remember one of the major laws of physics as well as balance sheet management, “for every action, there is a reaction.” Always be on the lookout for unintended consequences and thanks for tuning in.
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