Don’t Hitch Your Strategy to a Rate Forecast

Fate Has Earned Its Reputation

2019 may best be remembered as the year when things that weren’t supposed to happen, happened anyway. The world’s major economies weren’t supposed to have spiraled downwards, but they did. Bond yields were not supposed to have fallen, but that’s what happens when growth decelerates. The Fed was not supposed to have reversed monetary policy and cut rates, but that happened, too. Three times. The presence of these conditions would be less significant were it not for the fact that most community banks had been readying their balance sheets for rising interest rates ever since the end of the Great Recession almost eleven years ago.

And who could blame them? Since the beginning of the current growth cycle in mid-2009, regulatory authorities of all ilk have been loudly and repeatedly sounding the alarm of higher interest rates couched in their concern that this inexorable fate would harm earnings and impair capital. Risk, though, is a tricky thing. Its genesis does not typically spring from what is expected; rather, it comes from the unexpected things that sneak up on us.

As a result, most community banks are very well prepared for rising rates, a condition that doesn’t exist, but less well prepared for low and falling rates; circa 2019. Preparing a bank’s risk profile for only one environmental condition is the perfect strategy to employ as long as one’s prescience is also perfect. But, managing interest rate risk and/or an investment portfolio should not be about outguessing the market. Nor should it be about trying to get ahead of the Fed or making bets based upon economic forecasts that are less reliable than astrological ones. What if a bank could make itself indifferent to interest rates? What if earnings projections could be made to be consistent across a wide spectrum of interest rate backgrounds? What if risk managers prepared their balance sheets for more than one outcome?

Accomplishing these ideals sounds great as a concept, but in practice, very few institutions ever reach the promised land of interest rate indifference. One reason for this may just be the nature of human nature. Most people tend to think their beliefs and perceptions about the universe, including interest rates, are the correct ones. If they didn’t believe this, they would have different beliefs. Self-belief is a good thing, but so is self-awareness; managing risk for multiple outcomes requires at least a tacit admission that one’s view of the future might be wrong. Such an epiphany can suggest behavior that may seem to go against the grain.

The Boy Who Cried “Bear!”

In 2009, the winter edition of the FDIC publication Supervisory Insights contained a piece entitled “Nowhere to Go but Up: Managing Interest Rate Risk in a Low-Rate Environment.” It was filled with cautionary encouragement for banks to make preparations for higher market rates; not at all unreasonable given that short-term rates were barely hovering above zero. But also back then, Ten-Year Treasuries were yielding close to 4% and the nominal yield of the Bond Buyer 20 Year G.O. Muni Index was around 4.25%. Needless to say, those risk managers who were only managing for a single outcome, the one defined by higher rates, avoided such things. The “smart” money stayed short because that’s what smart money does when it “knows” rates have nowhere to go but up. As a result, many “smart” portfolio managers missed some big investment opportunities because their strategy was too invested in a perception that allowed no room for any world that didn’t involve higher and rising interest rates. A world that is still worlds away.

What If You Didn’t Have to be Right?

What about risk managers who operate without an overriding market bias? How do managers manage without an emotional investment in a rate forecast? They do it by allowing for the possibility of multiple outcomes, even some unlikely ones. Those portfolio managers who invested in twenty-year municipal bonds back in 2009 didn’t do it because they “knew” rates were going to fall, which they did; they did it because they didn’t know what rates were going to do. They loaded up on high cash-flow instruments at the same time and for the same reason: they didn’t know where rates were headed but they wanted to be ready for anything. And they have been. Their long-term, high-yielding bonds have provided much needed income during times when yields trended downward, and their reservoir of short-term cash flow has been a repricing boon for those times when rates trended higher or back-up liquidity was needed. Successful risk managers don’t have to be smart enough to see into the future, they just have to be smart enough to realize they can’t.

 

The Baker Group is one of the nation’s largest independently owned securities firms specializing in investment portfolio management for community financial institutions.

Since 1979, we’ve helped our clients improve decision-making, manage interest rate risk, and maximize investment portfolio performance. Our proven approach of total resource integration utilizes software and products developed by Baker’s Software Solutions* combined with the firm’s investment experience and advice.

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For More Information
The Baker Group's Lester Murray

Lester Murray

Associate Partner
The Baker Group LP

lester@GoBaker.com
800.937.2257

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