Wednesday, March 20, 2019 |
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| MANAGING DIRECTOR: Scott Carrithers PORTFOLIO SALES AND SERVICE: Steve Panknin • George Morris • Jeff Goble • Chris Thompson • Sean Doherty Kevin Doyle • Lonnie Harris • Mark Tranckino • Robert Schuyler • Tom Toburen • Josh Kiefer Nicole Burczyk • Kelley Frye • Natalie Regan • Aaron Stoffer • Chuck Honeywell • Gus Koppen |
| US Treasury Market | |||||||||||
| Date | 1 mo | 3 mo | 6 mo | 1 yr | 2 yr | 3 yr | 5 yr | 7 yr | 10 yr | 20 yr | 30 yr |
| 03/13/19 | 2.43 | 2.45 | 2.53 | 2.53 | 2.45 | 2.41 | 2.42 | 2.51 | 2.61 | 2.82 | 3.02 |
| 03/14/19 | 2.48 | 2.45 | 2.52 | 2.52 | 2.46 | 2.42 | 2.43 | 2.53 | 2.63 | 2.86 | 3.04 |
| 03/15/19 | 2.46 | 2.45 | 2.52 | 2.52 | 2.43 | 2.39 | 2.40 | 2.49 | 2.59 | 2.83 | 3.02 |
| 03/18/19 | 2.47 | 2.44 | 2.51 | 2.52 | 2.45 | 2.41 | 2.42 | 2.51 | 2.60 | 2.83 | 3.01 |
| 03/19/19 | 2.46 | 2.46 | 2.52 | 2.50 | 2.46 | 2.42 | 2.42 | 2.51 | 2.61 | 2.84 | 3.02 |
Source: U.S. Department of the Treasury, as of 03/19/2019
Markets in Transition; What to do Now? (Part 2)
Yesterday we discussed where the markets have come from, Bear Flattening, to where we think they may go, Bull Steepening. You can read it here if you missed it. In summary, these curves look like this:
These curve depictions don’t really tell the whole story. It is important to also understand what they represent in terms of the Rate Cycle. A capitalist economy is marked by periods of expansion and contraction, called the Business Cycle, which tend to follow (or coincide) with the interest rate cycle. Put simply, as the business cycle expands, interest rates tend to increase, as the business cycle contracts, interest rates predictably decline. As we would expect, Credit Cycles also follow a similar pattern. As business cycles expand and interest rates increase, the credit worthiness of borrowers also tends to increase, and likewise, credit deteriorates in contracting (declining rate) cycles. These can be thought of as looking something like this:
This should look very familiar to financial institutions, since we are in the business of extending credit, regardless of where we are in the cycle. The questions has to be, do we take the appropriate steps to mitigate risk both in terms of potential credit loss and potential interest rate risk at the most critical points of these cycles? Due to the Recency Bias discussed yesterday, for most of us the answer is sadly, no. (BTW, we do not exclude ourselves from this conclusion, as we are ALL susceptible).
Here is what we have observed over the years with regard to the investment portfolio (however the same principles apply to the overall balance sheet).
As rates peak, a financial institution will typically reduce the duration of their portfolio in response to several forces.
As rates decline (and the business cycle contracts), the dollars once allocated to the loan portfolio now get reallocated back into investments at lower and lower rates. Portfolio income follows interest rates lower. In order to meet the ever increasing demand for income, portfolios tend to get longer in duration in order to capture nominally higher yields out on the curve. Portfolio managers, under more pressure for additional income are often susceptible to buying “story bonds” that have less liquidity and generally more credit risk. As the credit cycle follows interest rates, stories begin to appear in the financial press of loan failures, securities defaults, and market dislocations as the prices on story bonds fall well below the levels anticipated in even the “worst” scenarios. This lowest point in the cycle is often linked to business failures, and in some cases bank failures.
Is there a way to avoid some of these pitfalls? Stay tuned for Part 3 in this series for some ideas on how we can all avoid the worst case scenarios.
In the meantime, we sincerely appreciate your continued confidence in all of us here at Country Club Bank. Please don’t hesitate to call on us if we can assist you in any way.
Markets in Transition; What to do Now? (Part 2)
Yesterday we discussed where the markets have come from, Bear Flattening, to where we think they may go, Bull Steepening. You can read it here if you missed it. In summary, these curves look like this:
These curve depictions don’t really tell the whole story. It is important to also understand what they represent in terms of the Rate Cycle. A capitalist economy is marked by periods of expansion and contraction, called the Business Cycle, which tend to follow (or coincide) with the interest rate cycle. Put simply, as the business cycle expands, interest rates tend to increase, as the business cycle contracts, interest rates predictably decline. As we would expect, Credit Cycles also follow a similar pattern. As business cycles expand and interest rates increase, the credit worthiness of borrowers also tends to increase, and likewise, credit deteriorates in contracting (declining rate) cycles. These can be thought of as looking something like this:
This should look very familiar to financial institutions, since we are in the business of extending credit, regardless of where we are in the cycle. The questions has to be, do we take the appropriate steps to mitigate risk both in terms of potential credit loss and potential interest rate risk at the most critical points of these cycles? Due to the Recency Bias discussed yesterday, for most of us the answer is sadly, no. (BTW, we do not exclude ourselves from this conclusion, as we are ALL susceptible).
Here is what we have observed over the years with regard to the investment portfolio (however the same principles apply to the overall balance sheet).
As rates peak, a financial institution will typically reduce the duration of their portfolio in response to several forces.
- As rates have risen, the portfolio loses value, and the board/senior management begin to question how the losses have gotten so big, so fast.
- Loan demand increases and the assets in the investment portfolio get reallocated to fund loans, shrinking the portfolio both in terms of dollars and duration.
- Deposit growth slows, or becomes cost prohibitive, so investment assets are either sold, or left uninvested in order to meet other liquidity demands.
As rates decline (and the business cycle contracts), the dollars once allocated to the loan portfolio now get reallocated back into investments at lower and lower rates. Portfolio income follows interest rates lower. In order to meet the ever increasing demand for income, portfolios tend to get longer in duration in order to capture nominally higher yields out on the curve. Portfolio managers, under more pressure for additional income are often susceptible to buying “story bonds” that have less liquidity and generally more credit risk. As the credit cycle follows interest rates, stories begin to appear in the financial press of loan failures, securities defaults, and market dislocations as the prices on story bonds fall well below the levels anticipated in even the “worst” scenarios. This lowest point in the cycle is often linked to business failures, and in some cases bank failures.
Is there a way to avoid some of these pitfalls? Stay tuned for Part 3 in this series for some ideas on how we can all avoid the worst case scenarios.
In the meantime, we sincerely appreciate your continued confidence in all of us here at Country Club Bank. Please don’t hesitate to call on us if we can assist you in any way.
This information is intended for institutional investors only. The material provided in this document/presentation is for informational purposes only and is intended solely for private use. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instruments.
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