Funding Strategies Ahead of the Taper

Short-term interest rates are currently near zero, as they were from 2009 to 2015, and the Federal Reserve is conducting a large-scale Quantitative Easing (QE) bond-buying program. Beyond those two key similarities, many differences begin to emerge when comparing the Great Financial Crisis and today’s COVID-19 pandemic. However, looking back at how certain aspects of the financial system fared at that time can be instructive for today.

Recent public comments from Federal Reserve officials have hinted that it may be appropriate for the Fed to soon reduce, or taper, its $120 billion per month purchases of Treasurys and mortgage- backed Securities. In the interest of signaling the intended messages and supporting the smooth functioning of markets, their comments have been careful to separate the timeline for tapering from the timeline for short-term rate hikes. This is likely driven from the experience in 2013 when the infamous “Taper Tantrum” occurred and abruptly drove long-term rates higher ​simply because the mere mention of a possible tapering caught many market participants off-guard.

While the 10-year Treasury rose initially at the hint of tapering in mid-2013, once it was implemented towards the end of the year, rates fell. Rates dropping with the removal of a large consistent buyer and source of demand may seem counterintuitive, but this reaction was consistent with what was seen in the previous versions of QE: long-term rates rose while the Fed was engaged in bond buying, and they fell when they were not buying. Compared to the lows hit in mid-2020, currently long-term rates are showing a similar pattern as they are 75 to 100 basis points higher even as the Fed continues to buy each month.

Turning to the short end of the yield curve, once the Fed saw sufficient progress in the economic recovery to raise short-term rates, depository funding costs exhibited an interesting dynamic. The chart below shows the upper limit of the Fed Funds range as well as the median cost of interest-bearing deposits for FHLBank Boston bank and credit union members from June 2015 to the same period in 2017. As the Fed lifted rates by 100 basis points over an 18-month period, depositories were able to hold firm on raising their rates. This low-beta relationship afforded members the ability to see margin expansion as funding costs remained stable while asset yields improved and loan growth accelerated. It wasn’t until the second 100 basis points of hikes in 2018 that deposit costs started to drift higher.

Over the last year, many members have experienced what can be described as “reluctant leverage.” In the wake of various fiscal and monetary actions taken in response to the pandemic, the growth in core deposits has been historic and led to a reduction in capital ratios for many members. FHLBank Boston depository members saw median deposit growth of nearly 30% and a median reduction in their capital ratio of over 100 basis points from the fourth quarter of 2019 to the second quarter of 2021.

That reduction in capital ratios hasn’t necessarily created riskier balance sheets. Finding suitable and sufficient assets to deploy that deposit surge has been a challenge, especially as Paycheck Protection Program loans, investments and cash have grown sharply, outpacing commercial or residential loans. 

Looking at risk-based capital (RBC) ratios for bank members (note: credit unions do not report risk-based capital) confirms that. Despite relatively more leveraged balance sheets, the asset side is being deployed into more conservative instruments. RBC ratios are generally flat to slightly higher now compared to pre-pandemic levels, driven by lower loan to asset ratios and despite lower nominal capital ratios.

According to Mark Twain, “History never repeats itself, but it does often rhyme.” What can depositories be doing now to position their balance sheets in an optimal fashion ahead of an approaching taper followed by potential rate hikes? Let’s consider a couple of actions that can be put into place.

While many members have already seen significant repricing benefits from lowering deposit rates, every basis point matters that much more in the current environment where margins are under pressure. As the comparison below shows, money market rates across New England have come down on an absolute basis when compared to pre-COVID levels. However, on a relative basis versus where FHLBank Boston members can efficiently access the incremental dollar of funding with advances, there may be some room to further ratchet down deposit rates. This is especially true if, as mentioned above, members believe that they will have pricing leverage as tapering and hikes commence.

For members with some combination of (a) high asset sensitivity, (b) a strong capital position, and/or (c) conservative forecasts on loan demand, balance sheet growth via investment leverage may be warranted. Tepid (albeit improving) loan demand with narrow spreads is a less than ideal backdrop for many, but deploying assets in the belly of the curve and funding on the front end may be risk-reducing for the overall balance sheet as some of the asset sensitivity position is used to offset the lagging contributions from volume and spread. 

As the chart below shows, several FHLBank Boston advance solutions, such as floating-rate advances like the SOFR-Indexed Advance and Discount Note Auction-Floater Advance, can be used to capture initial spreads upwards of 100 basis points.

In contrast to the last example, if a member is more inclined to manage down sensitivity to rising intermediate rates, then there are ways to do that with advances as well.                                                                                                         

• Don’t need new funding but want to reduce interest-rate risk starting at some point in the future: Consider using the Forward Starting Advance to take advantage of the current low and flat level of the yield curve but delay the disbursement of funds to a date in the future.              
• Already have funding and don’t need new funding but want to reduce interest-rate risk immediately: For some with existing advances already on the books, you may be able to execute an advance restructure, extending the maturity to reduce interest-rate risk and lower interest expense in the process, all while not adding incremental funding. 
• Seeking new funding: For those who have managed cash levels tightly, have asset growth opportunities, and are inclined to hedge interest-rate risk, options exist to fund near historically low rates and tight spreads. In addition to the Classic Advance, the Symmetrical Prepayment Advance can offer added flexibility and, for those members who utilize derivatives, the SOFR-Indexed Advance can be used in a strategy that provides additional liquidity and operational relief on top of the rate-risk benefits.

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 the unique needs of your balance sheet. Please contact me at 617-292-9644 or andrew.paolillo@fhlbboston.com, or 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.