2018: The Year of Anxiety and Deliberation as Talk of Inversion Reigns Supreme

What’s an Asset/Liability Committee (ALCO) to Do in Times of Uncertainty?
The prospect of an “inverted yield curve” has been a frequent topic of conversation; dominating recent headlines.  No three words cause investors more heartburn because inversions are often an early warning of impending slower economic growth and have preceded past recessions. 

The yield curve is a graphical representation of interest rates of a similar debt contracts over times. This curve plots out the yields of various Treasury instruments based on their maturity. Generally, bills with shorter maturities (e.g. 3 months) should have lower yields than notes or bonds with maturities of 10 years or 30 years. This represents an upward-sloping (normal) yield curve, which is usually a sign of a healthy, expanding economy.

A flat yield curve is one where long-term notes/bonds have approximately the same yield as shorter-term bills. This is often a sign of an upcoming transition from expansion to recession.

Source: FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org
The Treasury curve has flattened dramatically over the course of 2018; including the last month.

An inverted yield curve occurs when shorter-maturity bills have higher interest rates than longer-maturity notes. An inverted yield curve is often a reliable indicator of an impending recession. At 108 months, the current economic expansion, that began in Jun-09, is now the second longest in U.S. history.

Source: https://seekingalpha.com/article/4185754-length-economic-expansions

Volatility in one market frequently drives investors towards the security and stability of others; often referred to as a “flight to safety.” For example, the price of crude oil has declined almost 40%; to ~$46/barrel currently, from ~$75 in October.  As a result, energy stocks have fallen significantly as money moved out of equities and into the Treasury market; thereby lowering yields.  More broadly, the S&P 500 is down 15% over the last quarter; further pushing yields lower as investor fear of recession pushed the Energy, Materials and Financial sectors into bear market territory (i.e. down 20% or more).

After reaching a 2018 high of 3.30%, 10-year note yields began declining in mid-November amid Fed concerns over softer global growth. After saying the Fed was “a long way” from neutral in early October, Fed Chairman, Jerome Powell, said Wednesday (11/28) he considers the central bank’s benchmark interest rate to be near a neutral level, an important distinction from remarks he made less than two months ago. Nonetheless, the FOMC decided to hike its benchmark overnight lending rate by one quarter point on Wednesday (12/19) to a target range between 2.25 to 2.5%; pushing 10-year Treasury yields 5 bps lower; to 2.7793%. 

The market (Fed Funds Futures) is now betting that global growth headwinds, geopolitical concerns, and lack of excessive inflation pressure will keep the Fed on hold for the foreseeable future.

Source: CME Group—FedWatch Tool

Whether it is uncertainty regarding Fed monetary policy, Brexit or the ongoing trade war with China, the yield curve is causing a lot of angst. Inversions are perceived as a negative for Wall Street because it discourages banks (the engine of most financial markets), which borrow on a short-term basis and lend over a longer term, from lending.  Although economists consider the yield curve a reliable bellwether for coming recessions, an inversion typically precedes a recession by one or two years. That said, the market will turn sometime in late 2019 or 2020; if historic patterns hold true. It is important to note that this is a correlation, not a causation. Bond prices do not drive a recession. They just signal how bankers see the market.

All that being said, bank ALCO’s are tasked with measuring risk and evaluating strategies to mitigate those risks; rather than trying to predict the future path of interest rates.  In the last issue of our Risk Analytics Journal, I introduced a proactive approach to IRR management.  Again, I want to reiterate the importance of ALCO Committee’s being proactive in discussing potential risk and strategies to mitigate NIM erosion at each meeting.

The curve continues to flatten (as shown below), which may or may not foretell a recession.

Based on the most recent Fed Summary of Economic Projections, however, the economy is “only” projected to slow down over the longer run.

Nonetheless, asset-sensitive institutions should consider the risk mitigation strategies described below.

Strategies to Reduce Risk Associated with Asset-Sensitivity:
  1. Buy fixed-rate/longer duration securities and/or loans
  2. Floating-rate funding
  3. Structured repurchase agreements with 
    embedded floors.
  4. Buy floors outright
  5. Enter receive fixed, pay floating swaps
  6. As the curve flattens towards 0bps (during a Fed tightening cycle), 
    sell caps and buy floors.
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