Preparation Is Key to Quick Adaptation to Possible Yield Curve Inversion
As the Federal Reserve raises rates (from near zero in the wake of the 2008 financial crisis to 2.25 percent today, with additional hikes on the horizon), the yield curve has flattened, sparking debate about a possible inversion. Commonly monitored via the spread between the Treasury 2-year and 10-year bond yields, the yield curve is one of many data sets economists and financial professionals use to gauge the behavior and health of the economy and market. Yield curve inversions are among the most accurate and timely predictors of economic recession, having preceded all nine recessions since 1955. For banks, a yield curve inversion presents several challenges, including margin compression and the fallout from a potential recession. The best way to mitigate these risks is to develop an action plan now that can be utilized if an inversion occurs.
Don't Predict. Prepare.
Banks should always be concerned with directional changes to the yield curve, says Marty Thomas, manager at Wipfli, since moving sharply up, ongoing flattening, and flattening further into an inversion all require preparing different investment, loan, and deposit/funding strategies. Rather than spend time and resources trying to predict which of those scenarios is the most likely, banks should create action plans for each and adjust often based on realized economic conditions. "The best advice is to anticipate, but don't predict," said Dale Sheller, vice president, The Baker Group, LP. "Be proactive and not reactive with your balance sheet strategies."
One scenario is an extended period with a very flat curve. "It is quite possible we could have a flat yield curve for a prolonged amount of time before we see an actual inversion," said Sheller. If that occurs, the biggest challenge for banks will be maintaining healthy net interest margins, which are typically stronger in a steeper curve. "A prolonged flattening is as much or more of a concern as an inversion," said Marc Gall, vice president, BOK Financial Institution Advisors. A prolonged flat curve may or may not be followed by an inversion, however. "Just because the curve is flat doesn't necessarily mean it's going to invert," said Dudley Carter, economist with Vining Sparks. "Look at 1995-2000. The yield curve got very flat and stayed there for years, and the economy was very strong." He pointed out that while margins are compressed, banks are seeing loan growth and strength in other areas of the business.
Another possibility is the curve inversion everyone is talking about. Some financial pundits claim, for a variety of reasons, that a yield curve inversion today doesn't present the same risk of recession as previous inversions. On the other hand, better safe than sorry. "An inverted yield curve is the most accurate, timely indicator that you're nearing the peak of an economic cycle," Carter explained. "'It's different this time' is a dangerous stance to take." One key factor to consider when creating a reaction plan to an inversion is identifying what caused it. Sometimes the yield curve inverts for a short period of time due to market fluctuations caused by exogenous events; other times the Federal Reserve has taken a contractionary policy stance and raised rates as a precaution against inflation, causing an inversion. Whatever the cause, banks should be concerned about the economic recession that follows an inversion. "For any bank, profitability is the bottom line," said Kent Musbach, senior vice president, BOK Financial Institution Advisors. "The most concerning thing for a community bank from an earnings standpoint is a recession." The two biggest hits to banks during recessions are loan losses and a decrease in the percentage of loans that are earning assets, he explained.
5 Tactics to Consider
With those potential scenarios in mind, banks should identify the specific actions they will take in response. Below are five tactics for bank leadership to consider in response to continued flattening of the yield curve and an eventual inversion—the two most likely scenarios for the near future. One important caveat: the strategies implemented must be based on the institution's unique balance sheet and business model. "Every bank is different," Carter explained. "The nuances of a bank's business model and balance sheet will impact how they manage through a flattening—and potentially inverted—yield curve."
1: Leverage Your A/L Models
Every bank has an asset/liability management team and bank simulation models. Thomas recommends utilizing them to identify the strategies that will work best for the bank from a holistic perspective. "Test multiple strategies in your ALM model, initially one element at a time, and then combine them into a total bank simulation," he said. "What might look good as an investment strategy may not work as well when loan and/or deposit strategies are melded into a total bank simulation." Those same models can also be used to refine the bank's strategies based on new economic data.
2: Modify Your IRR Strategy
On a related note, it is essential for banks to adapt their interest rate risk strategies as the curve changes, which will require a shift in focus for many banks. "When we were at zero for so long, there wasn't as much risk for falling rates, so banks have been focused on the rising side for a long time," Carter explained. "Now that rates have risen, don't forget there's a left side to the shock table and that rates can fall." On the asset side, Musbach suggests putting floors in variable rate loans and adding prepayment penalties to fixed rate loans. "If the yield curve is right and we end up going into a recession, interest rates will likely fall at that point, and you don't want your higher-earning assets to go away," he explained. Gall recommends conducting a two- or three-year forecast on net interest margin to create a forward-looking projection on how much the bank's cost of funds is likely to increase compared to cost of assets. "Then you can identify where you need to make changes," he explained. "If you wait for it to happen, you're already too late."
3: Align Your Investment Portfolio With Balance Sheet Changes
Banks should also adjust their investment strategy to accommodate changes in the rest of the balance sheet. Sheller recommends "subtle tweaks" to the investment portfolio strategy rather than wholesale changes. "You need to slowly change your strategy as you prepare for a yield curve inversion, a recession, and therefore a pullback in interest rates," he said. "Each portfolio is unique in its current investment sector allocations, and each investment portfolio strategy needs to align with the changes to the rest of the balance sheet, including loan demand and deposit growth or runoff." Thomas recommends longer durations in the investment portfolio and stratified yielding deposit accounts available to help retain depositors as rates rise.
4: Focus on Credit Quality
One of the most important steps banks can take today to prepare for changes in the yield curve is to increase their focus on credit quality. "Make sure that your loan portfolio credit profile is as clean as it can be to get you through an economic downturn," Gall advised. That doesn't necessarily mean tightening credit standards, but rather being mindful of the impact long-term deals could have on the balance sheet. "Once the yield curve inverts, the decisions have already been made on credit risk," Gall continued. "You've already accepted the risk for a long horizon. Prepare today for how long that relationship is going to stick with you and make sure you're comfortable with it in the event the economic environment changes."
5: Execute With Careful Timing
The most important tactic is for bank leadership to not act until circumstances show that it is necessary. Changing strategies too soon creates risk that the bank may miss out on potential profits during a prolonged flattening. "Work with your management team and board of directors on a strategic plan to respond to the ripple effects that tend to be associated with an economic slowdown," Carter said. "And once the curve inverts, not before, start executing that plan to help guide your bank through a period of potentially turbulent waters."
BOK Financial Institution Advisors is a WBA Gold Associate Member.
Wipfli is a WBA Silver Associate Member.
The Baker Group, LP is a WBA Bronze Associate Member.
Vining Sparks is part of ICBA Securities Network, a WBA Gold Associate Member.