Many community bankers are now considering how to position their asset and liability portfolios for declining interest rates. On the one hand, interest rates should be falling more, and on the other hand interest rates are being talked down against a backdrop of still strong economic data. In this article, we share some of our views on how some community bankers are positioning their commercial loans based on current uncertainty in the interest rate environment.
The forward interest rate market is pricing a 98% probability of at least one interest rate cut this year – that is a very high probability based on a substantial amount of contracts outstanding. By the end of 2019, that same futures market is pricing in a total of three expected cuts. By contrast, according to economists surveyed by Bloomberg last week, the Fed will lower rates by only a 25bps this year. A few economists still expect the Fed to raise rates later this year.
How should community bankers cut through this noise and position their commercial loans for success? We highlight three specific concepts that smart bankers are considering – the predictive value of the forward curve, addressing customer demand and understanding the difference between the market view and taking a contrarian view.
The Predictive Validity of Forward Rates
The Federal Reserve has signaled that it stands ready to cut rates if downside risks materialize. However, will downside risk materialize? The market is a very poor predictor of where interest rates will trend. There is an old saying on trading floors that goes like this: “I don’t care if you’re a genius or a moron, as long as you’re almost always right or almost always wrong, you add the same amount of value.” Here’s the problem with the forward curve, it is not always right or always wrong, but forward rates are generally a lousy predictor of the future.
Below is a graph showing in the blue line where short-term rates have been since 1985 to the present (Prime, LIBOR or Fed Funds are 99% correlated). In the dotted red line are forward rates for specific periods (the dotted red line furthest to the right is today’s forward curve). During inflection points, and at other points in the past, the forward rates were not good predictors of the future.
If the forward market is a poor predictor of the future, economists are probably even less reliable. For example, here is one quote from a prominent chief economist: “In determining future fed funds changes, it is necessary to handicap trade negotiations and that injects a significant amount of uncertainty in the outlook for rates.” That is a fancy way of saying, “I don’t know where rates will go, because I am not prescient, but I am getting paid to take a view, so I need to say something.”
Addressing Customer Demand
Community bankers should be listening to their customers and delivering the best products possible based on customer demand. Community bankers should stand ready to provide long-term fixed-rate loans, short-term fixed-rate loans, or floaters as customer demand warrants. Whether customers want short-term commitments or long-term commitments, bankers should be able to fill that need. Bankers should not change product offering to address the forward curve or economists predictions - we need to satisfy the client’s needs and figure out a way of addressing our ALM needs separately. We need to position our banks to solve our customers’ needs and not use our customers to solve our bank’s requirements.
Market View Or Contrarian View
As the possibility of interest rate cuts increased this year, bankers were considering their options to lock in yields and avoid adjustable rate assets. But that thinking is rather murky. Let us find the straightforward choice of making a 5-year floating versus a 5-year fixed rate loan. Which is a better asset for the bank? Assuming every other variable is the same (same prepayment protection, same probability of default, etc.) the answer is that the banker is indifferent to the two loans if that banker believes in the forward interest rate market. The expectation is that both loans will earn the same interest based on the predictive value of the forward interest rates (which we see is very low).
The only reason that a banker would have a preference for the fixed rate loan is if the banker thought that interest rates would fall more or faster than the forward market is predicting. On the other hand, a banker would have a preference for the floating rate loan if the banker believed that interest rates would fall less or slower than the forward market is predicting. If the market and economists find it difficult to predict forward rates, how can we believe that we can outwit the market and make a more valid prediction? We believe that most bankers should not have a view that is different from the market, and if you do not have a view contrary to the market, do what our first boss in banking taught us – keep your assets and liabilities short, and you will not go wrong.
There substantial concern by ALM committees about what interest rates will be doing in the future. Those concerns are well founded, and banks should be considering all of their options for assets and liabilities. However, bankers should keep this in mind – forward interest rates are a poor predictor of the future, we should offer customers what they want (and charge them for the privilege) and we should understand what the markets expect to happen, not try to outwit the market, and keep our assets and liabilities short.
Submitted by Chris Nichols on June 24, 2019