In January 2012, Ben Bernanke introduced the world to the FOMC’s first dot plot to clarify the Federal Reserve’s rate outlook. The median projections were for 25 bps to conclude 2012 and 2013 with a 75 bps median projection by the end of 2014. The market priced short-term rates more hawkish with three-month U.S. Treasuries implied to be at 130 bps by the end of 2014. Ultimately, they were both too aggressive, as the FOMC maintained the 25 bps upper bound range until December 2015. Investors who accepted the Fed’s low rate forward guidance outperformed as they extended loan and bond durations while lowering their cost of funds.
At the time, the dot plot was new and portfolio managers were skeptical. The effective fed funds rate had rarely been below 1% in the previous 50 years. A 0-25 bps range for an extended period was unparalleled. Today, the market is accustomed to a zero-rate environment, and the Fed is once again projecting a multiyear path of low rates. June’s dot plot had 100% of Fed governors with a 0-25 bps range in 2020 and 2021. Only two Fed governors dissented from the 0-25 bps range in 2022. The market is in line with the dot plot: Fed Fund Futures imply a 0.24% effective fed funds rate in three years. However, depositories face a unique challenge compared to the Great Recession — low cost of funds.
In December 2008, when the effective fed funds range first reached 0-25, the average COFs for banks under $10BN was 2.53%. Over the next three years, they lowered their COFs by over 150 bps to 0.97% to support NIM. As of the 2020 Q2 call reports, banks under $10BN have a COFs of only 62 bps. Reducing COFs to protect margin will be more challenging in this round of low rates, so depositories will need to make the most of their investments. Fortunately, with the Fed’s guidance, portfolio managers have a blueprint for investing lower for longer environment.
Invest in Longer Duration Securities With Call Protection
Banks and credit unions have a historic amount of excess liquidity. Many institutions deploy extra funds into longer investments with call protection such as CMBS and municipals. The expectation of low COFs grants them the ability to extend with muted fear of margin compression due to rising rates. Additionally, the curve has steepened with the Fed’s most recent comments regarding higher inflation levels. The spread between five and ten-year U.S. Treasurys is near three years wide. The curve encourages investors to extend to improve earnings and generate gains from rolling down the curve.
Depository studies and forecasts lack a “pandemic shock.” Therefore, the outflow of excess liquidity is uncertain. Deposits have been stickier than anticipated, but with the conclusion of many government programs and the gridlock in Congress, the lack of future government intervention may cause deposit balances to fall. Institutions that are hesitant to deploy the excess liquidity because of deposit uncertainty can employ leverage strategies to take advantage of low borrowing costs on the front end of the curve and the spread over the last five years. ROA and NIM may compress, but the net income and ROE will improve, and capital ratios will support it.
The lack of lending opportunities has renewed the focus on the investment portfolio. Even institutions without a surplus of liquidity and those who do not wish to borrow can utilize the existing portfolio to improve earnings and take advantage of the curve. The Fed intervention in the fixed-income market tightened spreads across most sectors, especially on the front end of the curve. By selling short bonds into the Fed’s bid, investors can realize gains and position the portfolio into a more attractive part of the curve that will protect NIM.
More Aggressive Loan Terms
Banks historically gravitate toward short term or floating rate loans to lower interest rate risk. They would rather portfolio a 3/1 ARM than a 30-year fixed-rate mortgage. With the Fed’s low forward rate guidance, deposit rates are not expected to increase. Therefore, institutions can hold more fixed-rate loans than has been historically possible. Longer fixed-rate loans will generate more coupon revenue, and the longer fixed-rate lock will protect NIM against low rates. Depositories will also become more competitive in their local markets by offering more fixed-rate loans. Additionally, banks can sell or participate in existing floating-rate loans knowing that the coupon is unlikely to improve in the near term.
Due largely to PPP, community banks have had attractive earnings in 2020. With interest rates expected to remain low and lending opportunities waning, 2021 is poised to be a more challenging year for revenue. Thank the Fed for the investment blueprint to prepare for this lower-for-longer environment.
By Robert Biggs, Senior Market Analyst, Fixed-Income Strategies Group
Adam Saslawsky, Vice President, Fixed-Income Sales
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