Combatting Margin Pressure

The current interest-rate environment is challenging financial institutions, as the yield curve has remained inverted for longer than many expected. If we rewind to spring 2023 and look at the market-implied expectations for where short-term rates were predicted to be in spring 2024, we should already be in the rate-cut part of the cycle. However, that has proven to not be the case, as the Federal Reserve (the Fed) has thus far held steady on rates. Recent economic data supports the argument that the Fed will continue to delay rate cuts and reduce their magnitude. 

The chart below shows an analysis of the Consumer Price Index (CPI), which is the oft-referenced gauge of inflation. While the year-over-year change in percentage terms has dropped relative to the extraordinarily high levels experienced in 2021, it has only fallen to the 3.0-3.5% range, far above the 2% level the Fed has targeted as the precursor to pivoting to rate cuts. However, the year-over-year change doesn’t fully capture the compounded effect of high inflation. While the rate of change may have slowed, the price index is still significantly elevated compared to a consistent 2% trendline. 

The lack of run-off happening in the Fed’s mortgage-backed securities (MBS) portfolio that expanded so rapidly during Quantitative Easing in 2020 and 2021 is another interesting data point that supports the idea that rate cuts may not be imminent. The chart below shows the Fed Funds rate and the Fed’s MBS holdings during times of Quantitative Easing or Tightening since 2020. Rapid rate hikes have shouldered the bulk of work toward tightening financial conditions, as the MBS portfolio has been very slow to pay down, given tepid prepayments. It would be challenging to see a shift to an easing monetary stance while the Fed’s retained MBS portfolio is still $1 trillion higher than when Quantitative Easing commenced in March 2020. Their portfolio has paid down by “only” $400 billion in the two years since the shift to Quantitative Tightening in May 2022.

One common refrain from depository members is that their interest-rate risk profile has shifted considerably over the last two years. Where they used to be asset sensitive, they are now liability sensitive due to asset extension and a shift in their deposit profile from non-maturity deposits to short-term certificates of deposits. Accordingly, when looking at income simulation results, many are positioned to experience continued margin and earnings pressure in the near term, followed by improving conditions over time. A visualization of the earnings at risk profile resembles a checkmark, as funding cost pressure ramps up in the near term before receding, and asset yields slowly but surely reprice higher.

A popular strategy for many FHLBank Boston members has been to incrementally increase the duration of their borrowings to counterbalance the aforementioned extension risk on the asset side of their balance sheet and contraction risk in their deposit portfolio. To the extent that capital levels and liquidity metrics afford flexibility, investment leverage may have relative appeal in the current environment. An approach that adds assets in the intermediate range (five to seven years) with slightly shorter funding (one to three years) provides interest-rate risk-neutral income in the near term while adding liability sensitivity in the long term. That profile balances the exposure mentioned above that many find themselves in now, needing earnings support in the present while being better equipped to handle a duration mismatch beyond year one or two. 

Consider using a combination of Classic and HLB-Option Advances in a blended funding strategy. The table below uses four equal amounts, with a 50/50 split between short bullets and intermediate-term putable advances. As risk tolerances and return objectives vary, members can tailor the advances (type, part of the curve, amounts) to meet their needs.

In this example, the member has a blended rate of 4.78%, which, if used to fund a MBS at 6%, would produce a spread of nearly 125 basis points. In a down-rate scenario, the HLB-Option Advances are likely to extend towards their stated maturity. 

In contrast, in a rising-rate scenario, the probability increases that the advance will be put back at the end of the lockout period. This variability in the timing of principal cash flows allows for funding rates below Classic Advance rates. With 50% of the total funding set to mature within the first year, the member would have significant flexibility to benefit from a drop in wholesale rates, an improved climate for deposit gathering, or an acceleration in prepayments and cash flow from existing assets. Additionally, in a down-rate scenario where the HLB-Option Advances may extend, it’s likely that other parts of the balance sheet will see a favorable reversal of the impact experienced in 2023 and 2024 – deposit pricing pressure may abate, and low coupon fixed-rate assets that were added in 2020 and 2021 (mortgages and investments) would see their market values recover.

Recent market conditions have created challenges and opportunities for FHLBank Boston members. Our Financial Strategies group has developed a suite of analytical tools designed to help you identify the funding solutions that best fit your balance sheet's unique needs. Please contact me at 617-292-9644 or andrew.paolillo@fhlbboston.com or reach out to your relationship manager for more details.

FHLBank Boston does not act as a financial advisor, and members should independently evaluate the suitability and risks of all advances.  The content of this article is provided free of charge and is intended for general informational purposes only, FHLBank Boston does not guarantee the accuracy of third-party information displayed in this article, the views expressed herein do not necessarily represent the view of FHLBank Boston or its management, and members should independently evaluate the suitability and risks of all advances.