Insights May 28, 2024 March Madness: Digesting Q1 and the Latest FOMC Projections March Madness brings spring, but financial markets hope for calm. Lessons from bracketology apply to banking: Stay disciplined, hedge wisely, and expect surprises. High performing banks maintain discipline in hedging amid rate uncertainty. “Survive and advance” with prudent risk management. Isaac Wheeler Head of Balance Sheet Strategy March Madness is a wonderful time of year as it ushers in spring. But we sincerely hope that the madness stays on the basketball courts and out of the market. Some lessons we learn each year from bracketology can be applied to banking risk management: Stay disciplined, don’t pick winners with your heart, and expect the unexpected. For the new clients and those of you new to our webinar series, each quarter we take a close look at (publicly traded) bank earnings calls and appraise the state of customer hedging programs and other initiatives to let you know how they are navigating current conditions. In the March 26 webinar, two of Derivative Path’s most accurate long-distance shooters, Isaac Wheeler, Managing Director of Balance Sheet Strategy and Frank Fiorilli, Managing Director, Bank Solutions discussed the undercurrents of market trends, regulatory changes, and economic indicators currently paramount for professionals navigating the interest rate derivatives market. Here are some practical learnings from earnings calls data and some takeaways from last week’s FOMC meeting, Banks are maintaining discipline in hedging The market experts at Derivative Path were mostly encouraged by banking activities in Q4 2023 and early 2024. Wheeler noted that we saw the most references to customer hedging programs in years. While the hedging volumes decreased significantly, flows were more balanced and we found it particularly comforting that banks had continued executing hedges against rising rates. With the cautious Fed indicating a 75-point total cut planned in 2024, banks would do well to not take eyes off the ball from an upside rate risk standpoint. The lessons of the last rising rate cycle have remained sticky, and institutions have fundamentally redesigned hedging programs to be more proactive. Banks stay focused on interest rate risk management The focus on disciplined risk management is good to see because today’s more methodical soft landing is not very similar to the 1990s soft landing. Instead, if we do indeed see 75 points in cuts by the end of 2024, we will still have another 1.5-2% worth of cuts on the docket, a long way to go to achieve the Fed’s target. This brought up another fascinating question among the webinar’s panelists: Where will the neutral rate be when all is said and done? How close to 3% will we land? Until we know with some certainty, banks will still be conducting business in a volatile time. Rate cuts would be helpful from a customer perspective, although Fiorilli cautioned that they should not assume there will be a material decline in term rates. When looking at the 10-year point of the curve, rates are only expected to come down 10 to 15 basis points over that same period. Consider downside rates protection Wheeler pointed out that there is a possibility that rates will remain high. The FOMC concluded, “The Committee judges that the risks to achieving its employment and inflation goals are moving into better balance. The economic outlook is uncertain, and the Committee remains highly attentive to inflation risks.” If inflation cooperates and the Fed lowers rates this year, banks with fundamental exposure to a declining rate environment should establish some downside rates protection. There is naturally a cost to hedging. For creative strategies in an earnings-friendly manner, see our earlier post that covers some flexible, diverse hedging strategies. Evaluate risk monthly — and hedge accordingly As we have said before, customer hedging and balance sheet hedging programs are not an on-and-off switch but a systematic approach to doing business, and a foolproof way to avoid the temptation to try to market time. The highest performing banks know that balance sheet hedging is not a once or twice a year activity. They programmatically evaluate risk monthly — and hedge accordingly. Survive and advance in a higher-for-longer current rate environment A swap program eliminates the risk of that spread to be reduced in a higher-for-longer rate environment. As in the NCAA Tournament, this feeds a practical survive and advance mentality. Additionally, institutions that maintain consistency within loan level hedging programs can mitigate serious long-term agony for bank returns that may occur should the neutral rate end up higher than the mid-twos. Underappreciated risks Some banks may operate under the impression that fixed rate loans protect them in case of a recession if rates were to plummet. And from a modeling perspective, we would naturally agree when looking at the delta between how low rates have gone and the fixed rate. But in practice, customers will look to refinance at the lower rate, therefore that perceived protection goes unrealized. Likewise, if banks put a 2% or 3% floor in their loans, it looks good from a modeling perspective and will protect them. But if the SOFR (Secured Overnight Funding Rate) goes below the 2% or 3% floor, clients most often will refinance. The only genuine protection is a true ALM hedge, if that is what the bank is most concerned with from a bank return standpoint. It is essential that banks educate their staff and customers to practical balance sheet and customer hedging strategies. High performing institutions will be vigilant in extracting opportunities from existing hedge portfolios and align lending teams with the institution’s broader risk management approaches. Banks that maintain consistent risk management programs will be best positioned to manage interest rate movements. The long-term business of banking is mostly a business of managing spreads, not absolute rates. To view the entire “March Madness: Digesting Q1 and the Latest FOMC Projections” webinar, click here. If you have questions or comments, contact us here. We are always interested in hearing from you.
Article, Insights Market volatility can create risk management opportunities. Are you prepared to act when opportunity knocks on your door?