A Quick Recap and Key Points to Ponder
Where We’ve Been:
It’s fair to say that 2019 was quite a transition year for Fed policy, interest rates, and the bond market. The yield on the 10-year US Treasury Note, after reaching an eight-year high of 3.24% in November of 2018, dropped sharply to less than 1.50% this past September. For its part, the Fed had pushed the funds rate to 2.50% by December of 2018, its ninth rate hike in three years. But they were soon forced to embrace the reality of weakening domestic growth, dormant inflation, and mounting signs of stress in the global economy. The outlook was also muddied by months of confused signals about US trade policy, which prevented businesses from having confidence in planning and capital expenditure decisions.
Financial markets, which abhor uncertainty, naturally began to price-in expectations for easier money and a lower policy rate. As is usually the case, the bond market was right and the Fed soon followed suit. Three rate cuts later, just in time for the holidays, we had the funds rate right on top of the 10-year yield of 1.75%. So, where do interest rates and markets go from here?
Having cut rates three times in 2019, the Fed would now love to engineer a soft landing. At this point they’ll want to see if what they’ve done so far will provide the glidepath. They run the risk, though, that the new year will bring disruptive crosscurrents that upset the balance. For example, recent disturbing behavior in the repo market may be a coal mine canary worth monitoring. Another would be corporate bonds, particularly those with lesser credits. When yield spreads on junk bonds widen out, trouble’s coming. And with so much of the corporate bond universe barely above investment grade, the ripple effect could be profound. A word to the wise: watch corporate bonds with a wary eye.
Strategy Thoughts for 2020:
- When determining investment strategy, some banks simply react to changes in their liquidity position. If loan growth slows and liquidity rises, they’ll commit more to the securities portfolio. Other banks are more proactive. They’ll see the value in positioning early for the next big move in rates, which at the moment is likely to be lower. That proactive approach makes much more sense, especially in an environment like we have currently. Normal balance sheet cyclicality will always play a role, but the best managed banks are those that read the signals from market behavior and yield curve trends, and make investment decisions accordingly.
- The bond portfolio can and should be used to lengthen or shorten duration, and to sculpt the cash flow profile of the balance sheet to take advantage of expected shifts in market rates and the yield curve. Remember, the investment portfolio is the tool with which banks can most easily correct asset/liability exposures and optimize the balance sheet for the rate environment.
- Banks should assess their appetite for tax-exempt income, and structure cash flows so that they’ll not experience painful reinvestment risk into lower yields as the Fed cuts rates. In other words, transition from protecting value to protecting income. And don’t forget, yield is an opinion but cash flow’s a fact. Lock in yield by anchoring the cash flow with stable paying or bullet-like bonds.
- Everything happens with a time lag. The impact of monetary policy, deposit pricing, or investment decisions made today will become manifest in bank performance at some point in the future. The cyclical ebbs and flows of liquidity are reflections of previous monetary policy and economic decisions, not the most recent move by the Fed. The trick for bank managers is to anticipate where we are in the cycle and make balance sheet adjustments accordingly, always with an eye toward the future.
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