There has been much discussion lately about the flattening of the yield curve. Some economists and analysts believe that the yield curve could invert in 2018. Much of this discussion has been focused on trading strategies and the relationship between the shape of the yield curve and the strength of the economy. However, the flattening of the yield curve has real consequences for community banks and their loan portfolios. If the yield curve does continue to flatten in 2018, the dominant loan structure for community banks will be challenged. Bankers should now be considering how to protect their loan portfolio and develop lending products that work best in a flattening yield curve environment.
Interest Rate Environment
The Federal Reserve cannot easily control the shape of the yield curve. Instead, the Fed can raise or lower the short-end of the curve by setting the target Fed Funds rate. The graph below shows where the members of the FOMC would set short-term rates based on their expectation of the future strength of the economy.
Currently, the market is fully pricing a 25bps interest rate increase at the December 13, 2017, FOMC meeting. Fed members expect three more 25bps increases in 2018 which will take the Fed Funds rate to between 2.00% and 2.25% by the end of next year. The short-end of the curve is poised to continue a slow and steady rise.
The belly of the curve, or the five-year rate, is not directly controlled by the actions of the Fed but is market driven. The five-year Treasury yield and Fed Funds rate are shown in the graph below. Outside of economic recessions, the five-year Treasury yield (in the red line) has been higher than the Fed Funds rate (in the blue line). This slope in the yield curve adds approximately 75bps in net interest margin for loan yield for the average community bank.
The difference between the five-year Treasury yield and Fed Funds rate is shown in the graph below. What is telling in the data is that the five-year Treasury yield has been relatively consistent over the course of the recovery, and now short-term rates are expected to continue to climb over the next three years.
If the Fed is successful in raising rates through 2018 and the five-year yield continues to behave as it has in the last 15 years, the line in the graph above will continue to decline.
Impact on Community Banks
The five-year fixed rate term loan is the dominant fixed rate loan structure for community banks. Since banks’ cost of funding is so closely tied to Fed Funds (and LIBOR), any increase in funding costs without an increase in loan yield will compress banks’ net interest margin (NIM). The current flattening of the yield curve and expected additional flattening that is expected over the next few years should be discussed in every bank’s asset-liability committee. Community banks need a loan product that can maintain (or preferably increase net interest margin) in a flattening yield curve environment.
Community banks must consider their options to migrate a certain portion of their loan portfolio to a floating rate structure or find another way to offset interest margin compression in the currently anticipated interest rate environment. Some possible solutions include shorter loan resets, FHLB fixed rate advances, and loan hedging strategies. Each option has advantages and disadvantages and must be considered in relation to the banks’ customer base, product mix, and management’s outlook.
We have some recommendations for banks that may be applicable in the current rate environment. In a future article, we will consider one solution to allow banks to take advantage of a flattening yield curve, mitigate credit risk, differentiate from market competitors and increase the lifetime value of a loan. The solution is not a silver bullet that will work for every loan, but it is a formidable strategy for larger loans and for more sophisticated customers.
Submitted by Chris Nichols on November 13, 2017