The countdown to higher rates continues despite the drama in Greece and the retracement of China. There is little ambiguity that rates will increase shortly and the question we would like to address is how banks should position their balance sheets for the expected shape of the yield curve. Put another way, what will be the shape of the yield curve in the future and what are the implications for loans, securities and deposit structures?
The situation reminds us of an old banking joke that is relevant once again.
Two old bank CEO friends, Mark and Karen, meet at a local watering hole to catch up.
Mark: The examiners just left the bank and we just got slapped with a consent order.
Karen: It could be worse.
Mark: I also found out that one of my best customers is slapping us with a lender liability lawsuit.
Karen: It could be worse.
Mark: On top of all that my CFO let me know that we will likely lose money next year if rates go up.
Karen: It could be worse.
Mark: How can you say that? I just told you that my bank is in shambles and all you can say is “It could be worse”. How can it be any worse?
Karen: It could happen to my bank.
Historical Shape of the Yield Curve
The graph below shows the term structure of rates. The green lines show historical yield curve shape from 1989. The blue line shows today’s yield curve shape. The red lines show the market’s expected yield curve shape in the future. The yield curve is shown from one-year tenor out to 30-year tenor. From 1989, the yield curve flattened every time short term rates were increased by the Federal Reserve. While the market always gets it wrong, nonetheless, here is what the market is telling us today: Short term rates will rise, but the yield curve will flatten as longer-term rates move very little. The market expects the yield curve to have only 100 basis points differential by the end of 2016 between one year and 30 years, and that differential is expected to drop to zero basis points by 2020.
What Happens to Long-term Rates
While historically the yield curve flattened when short-term rates rise, there are additional pressures in today’s market that will keep longer-term rates anchored. First, currently long-term inflation expectations are well anchored. This will act to keep long-term interest rates lower. Second, various secular factors will support demand for longer-maturity securities in the US – they include demographic changes that will require longer duration for money managers and pension funds, and as long as the US remains the reserve currency for the world, US Treasuries will remain well sought after. However, there is also a very powerful cyclical factor that may keep long-term rates lower for a long period: the Federal Reserve’s balance sheet has ballooned from $675B in 2002 to $4.44T today, and the vast majority of those assets are long-term Treasuries and MBS. The graph below shows the growth of assets held by the Fed. So far in the recovery cycle, the Fed has been reluctant to liquidate these assets, and in the foreseeable future it appears that these long-term assets will not be liquidated.
Implications for Banks
The historical thinking is that when rates rise, banks can replace lower yielding assets with higher yielding assets, helping to increase net interest margin (NIM). However, projections are showing us that the middle and long ends of the curve will not increase as much as the short end of the curve. Therefore, as bank’s cost of funding increases the replacement of higher earning assets will not be happening to the extent many bankers anticipate. For banks under $10B in total assets, the average Macaulay duration is 4 with substantial negative convexity. Therefore, the average bank is gaining 130 bps in NIM in carry interest (the difference in the curve between short-term COF and average term of the assets). If the yield curve shape materializes the way the market predicts, then banks under $10B will experience tremendous NIM pressure. This will be especially important after 2016 when the four and five-year rates show very little expected rise. After 2017, the market expects almost no movement in the five-year rate.
What Must Banks Do to Preserve Margin?
Now is the wrong time for banks to originate five-year fixed rate loans or floating rate loans with floors (which in many respects behave worse than fixed-rate assets when rates rise). From an internal rate of return perspective, banks must shorten fixed rate loan terms to three years or below and increase non-surge DDA. Banks also need to assess which deposit customers are valuable when short-term rates rise (commercial DDA and rate insensitive consumer accounts), and which loan customers are valuable when short-term rates rise but the middle and long-end of the curve is relatively stable. No one wants to be the butt of a bad banking joke. Work over the next 12 months to position your bank for yield curve movement and it will be you who will be doing the laughing.
Submitted by Chris Nichols on July 22, 2015