The Challenges of Preparing a Balance Sheet for a Fed Pivot

2022 was a humbling year for bond market prognosticators. At the beginning of 2022, the forward market projected a modest tightening of two 25 bp rate hikes in 2022. As we all know, what ultimately transpired was one of the most aggressive tightening episodes in Fed history.

As we move further into 2023, the consensus outlook for U.S. rates is more sanguine. Inflation is finally showing signs of moderating, giving the central bank the leeway to slow its tightening campaign.

It remains to be seen whether the Fed can pull off the delicate balancing act of reining in inflation while also engineering a soft landing for the economy. A premature easing of monetary policy could trigger a resurgence in inflation, whereas overly aggressive tightening could tip the economy into recession.

While the past year serves as a reminder of the hazards of relying too heavily on market forecasts, it does appear likely that the economy is entering a new phase characterized by weaker growth, a softer labor market, and easing price pressures. In light of this, it could be an opportune time for borrowers and lenders to revisit their hedging strategies to ensure that they are still aligned with their objectives and market views.

For asset-sensitive banks, the surge in short-term rates over the past year has been a boon to net interest margins, as their floating rate assets have repriced more rapidly than their liabilities. However, these institutions could see some of these gains evaporate if the Fed lowers rates next year. To hedge against this risk, some lenders are paying a premium to purchase an interest rate floor on their floating rate assets, or entering a collar to establish a worst-case floor rate and best-case cap rate for those assets.

While floors and collars can protect against large declines in rates, lenders are still exposed to any decline in rates down the floor, and in the case of the collar, they also forego the benefit of any increase in rates above the cap.

A renewed focus on liquidity

In the immediate aftermath of the pandemic, financial institutions generally found themselves awash with liquidity, holding more deposits than they could deploy in their core lending activities. Loan-to-deposit ratios at many banks fell to record lows. However, as the Fed has tightened policy over the past year, the situation has rapidly reversed. Institutions are facing deposit outflows as rate-sensitive borrowers seek higher-yielding alternatives. Banks are once again focused on securing longer-term core deposits and protecting the cost of those deposits to fund the growth of their loan books.

Banks are once again focused on securing longer-term core deposits and protecting the cost of those deposits to fund the growth of their loan books.

Given the inverted yield curve, banks can be seen lowering their deposit costs by swapping their floating-rate funding to fixed–creating synthetic fixed-rate term deposits, often at a substantial discount to other term-funding alternatives such as long-term FHLB advances. While swapping deposits to fixed can offer immediate savings in the current environment, it is important for lenders to bear in mind that they may also forego the benefit of lower funding costs in the future if rates subsequently reverse course.

Doing your due diligence

Before undertaking any hedging strategies, it is important to understand how the strategy will perform under various market scenarios and how it will impact your financial statements. If you do not have in-house analytical resources, partnering with a third-party advisor with the expertise and technology to prepare this analysis both at inception and on an ongoing basis over the life of the hedge could be beneficial.

While we may be nearing the end of the current tightening cycle, it seems unlikely that we will quickly return to the stable, rock-bottom borrowing costs that prevailed since the 2008 financial crisis. Heightened interest rate volatility may be with us for the foreseeable future.  In this uncertain environment, a proactive approach to interest rate management can ensure that your institution is well-positioned regardless of the Fed’s next move.

Disclaimer

The Term “Derivative Path” refers to affiliates, Derivative Path, Inc. and Derivative Path Hedging Solutions, Inc. Derivative Path, Inc. is headquartered in the State of California. Hedging advisory and execution services are provided through Derivative Path Hedging Solutions, Inc. (DPHS). DPHS is a Commodities Futures Trading Commission (CFTC) registered Introducing Broker (IB) and Commodity Trading Advisor (CTA) and member of the National Futures Association (NFA). This communication is for informational purposes only, is not an offer, solicitation, recommendation, or commitment for any transaction or to buy or sell any security or other financial product, and is not intended as investment advice or as a confirmation of any transaction. This communication is intended as an information resource only; Derivative Path has taken reasonable measures to ensure the accuracy of this communication. Any information contained herein is not warranted as to completeness or accuracy, and Derivative Path accepts no liability for its use or to update or keep any such information current. The content of this communication is subject to change at any time without notice. For additional information, you can read more here.