Listen to Your Balance Sheet, Not the Markets

wooden blocks with a green up arrow a percent sign and a red down arrow representing interest rates
Darnell Canada Photo
Managing Director
Darling Consulting Group

4 minutes

Avoid speculation and overreaction to swings in market rates by answering these four questions in your interest rate risk analysis.

On May 3, Jerome Powell and the Federal Open Markets Committee announced yet another fed funds rate hike (25 basis points). This marks the 11th consecutive rate hike since March 2022, totaling 500bps over the course of 14 months. The more noteworthy observation is that the FOMC decided on this rate increase after several larger regional bank failures and widespread fears of a crisis in the banking industry. This action and public comments from Fed officials send a clear message to the markets: FOMC monetary policy bias will remain hawkish against inflation. In short, they plan to keep the funds rate high and even may increase it further.

Meanwhile, the bond market has priced US Treasury bonds higher, creating an inversion in the yield curve. The negative spread/slope between two-year USTs and 10-year USTs is at a level that hasn’t been witnessed since the 1980s, the last time inflation was viewed as problematic for the economy. The fed funds futures market is pricing a FOMC rate cut in July and over 200bps of rate cuts over the next 12 months. This is important because it suggests the widespread market anticipates short term rates will soon be significantly lower than observed today.

Don’t Overreact to Rate Changes

There are strong and valid arguments to be made for both viewpoints on the economy and market rate outlook. This creates quite a dilemma for credit union risk managers. Net interest margins have been narrowing, considerably so during Q4 2022 and Q1 2023, and are expected to narrow further over the next few quarters as deposits become more expensive and overall funding compositions shift to be more highly weighted in CDs and wholesale funding. A strategy influenced by FOMC messaging (i.e., expectations for higher rates for longer) would include longer funding maturities and shorter asset durations. This could be painful if market rates do fall as the broad marketplace forecasts. A strategy influenced by the broad market outlook for falling rate conditions would involve adding fixed rate assets at yields that are very tight (or negative) spreads to short-term funding costs. This would worsen margin conditions that are already stressed and leave credit unions more vulnerable to Fed rate increases.

If there is lesson to be learned from the banking conditions observed during the 1980s, when elevated inflation levels, aggressive Fed action and a steep yield curve inversion reared their collective ugly heads and played a role in the failure of many community banking institutions, it is that risk managers should be very careful to avoid speculation on the Fed and diligent to evade temptations and pressures to overreact to sharp swings in the market rates.

4 ALM Strategy Questions

Asset and liability strategies should reflect the risk posture of your balance sheet. This places a strong premium on quality risk models and analysis. If your interest rate risk model only tells you how net interest income/net interest margins will react to a simple or standard increase/decrease in rates, you likely have a blind spot in your understanding of your true interest rate risk. If it doesn’t already, your interest rate risk analysis should help you answer the following questions:

  1. How much will the outlook for NII/NIM change if deposit pricing betas must be captured over a shorter time horizon than normally assumed? The deposit pricing lag that most credit unions benefited from during 2022 will likely cause faster/sharper pricing adjustments in 2023 in both flat and rising rate scenarios.
  2. Given the deposit pricing lag of 2022, to what degree would an inability to drop deposit rates impact NII/NIM outlook under falling rate scenarios? This will help determine how urgent you should be to protect against lower rate conditions (asset sensitive credit unions) or to what degree you should be careful in overextending on protection against rising rates (liability sensitive credit unions).
  3. How significant will NII/NIM sensitivity levels improve/worsen if asset and/or funding mix continues to change? Highly volatile liquidity conditions are likely to have an impact on your future interest rate risk posture.
  4. How will the interest rate risk posture change if the current steep curve inversion transition to exhibit a more positive slope? The yield curve rarely moves in a parallel manner.

The importance of sensitivity stress testing is critical to prudent strategy development in the current environment. Carefully construct the complexities you build into your interest rate risk analysis. Too many scenarios can be as harmful as too few scenarios, so don’t undermine the importance of presentation in helping your ALCO members digest the information your analysis provides. The current environment is not ripe with opportunities to increase revenue to cover rising operating costs, but it is littered with land mines that could blow up your future profit/loss statement.

Darnell Canada is a managing director for CUES Supplier member Darling Consulting Group, Newburyport, Massachusetts, a solutions firm that specializes in the area of asset/liability management for financial institutions. Canada works directly with C-suite executives helping them to understand the complexities of their balance sheet financial risks and providing guidance and unbiased advice on strategies that strengthen earnings performance. In addition to providing advice for margin improvement and risk mitigation, he helps financial institutions manage the rigors of challenging regulatory situations.

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