Preparing for the Fed Pivot

With short-term rates having increased significantly this year, there has been much discussion about how high they will go and when the hikes cease. Inverted yield curves, widening credit spreads, and weaker equity markets suggest market participants are betting that the Federal Reserve will switch course sooner rather than later. But expectations, implied from the futures markets and in the Fed’s publishing of their Dot Plot, have consistently readjusted higher as the Fed has remained steadfast with increasing rates.

A possible driver of this lies with the different conditions that exist right now for the two key metrics that the Fed identifies as its “dual mandate.” Maximum employment and stable prices are the monetary policy goals of the Federal Reserve. As shown in the chart below, the unemployment rate has been steadily decreasing over the last two years, is approaching historic lows, and not showing many signs of stress in the economy. However, looking at inflation via the Consumer Price Index (CPI) year-over-year change tells a different story. Recent prints of the CPI have been far above the 2% target and persisting at extremely high levels.

The Fed has been transparent in recent commentary that taming inflation is paramount, and raising short-term rates is the primary tool in accomplishing that goal.

To that end, until inflation shows signs of normalization, we may continue to see upward pressure not only on overnight rates, but also along the rest of the yield curve.

While no two economic cycles are identical, looking at historical precedent can benefit context. With the third consecutive 0.75% hike in November 2022 , this cycle’s trough to peak so far rivals the rate hikes in the past. The duration of the pause, or the number of days from the last hike to the eventual first cut, has varied but has been longer than in the more recent examples in 2000, 2006, and 2019. Those pauses were more than 200 days compared to 1984, 1989, and 1995, which saw much shorter pauses.

The juggling of the competing priorities of earnings and liquidity/interest-rate risk is always present, but its importance is that much more magnified when conditions are volatile like they are now. When strategizing how to allocate assets or structure funding, it will be vital to understand how different strategies perform in different environments. Let’s look at three scenarios:

1. Terminal rate continues to push higher and further into the future, as has been the case so far this year;
2. Pause/pivot does not occur quickly; and 
3. Pause/pivot happens suddenly and swiftly.

Below, we will look at some approaches that have potential to serve members well in the above-mentioned scenarios.

The below analysis shows the total potential funding costs for two strategies: utilizing a six-month fixed-rate Classic Advance  at 4.78% versus continually rolling a Daily Cash Manager position assuming a spread to SOFR of +25. If, as we have seen throughout 2022, market expectations continue to underestimate how much the Fed will lift rates, then a modest extension with fixed-rate funding is likely to outperform. 

At present, the shape and level of the yield curve approximately imply another 75-basis point hike in December, followed by moves of +50 and +25 in February and March, respectively. If upside surprises continue and 75-basis point hikes persist through March, the total cost for the fixed-rate solution will be less than the accumulated cost of rolling short.

In Funding Strategies for Volatile Markets, we discussed how interest-rate volatility has spiked, given the uncertainty surrounding markets and the economy. Higher volatility manifests itself and presents an opportunity on the asset side of the balance sheet in the form of wider spreads on prepayable assets like mortgage-backed securities. On the liability side, it comes via putable advances like the HLB-Option Advance  and the SOFR Flipper Advance. 

The chart below highlights the rates on HLB-Option Advances  relative to Classic Advances  for structures with varying maturities and lockout periods. The HLB-Option Advance  curves underscore that the rates get lower as you extend maturities and/or shorten the lockout period. Savings can be upwards of 150 basis points or more compared to Classic Advances.

If the next Fed surprise results in rate hikes stopping and turning into rate cuts, then being able to reprice liabilities quickly will be a key contributor to margin in future periods. For an institution that may be asset sensitive and tight on liquidity, long-term fixed-rate borrowings may not be an ideal fit for the balance sheet. The term liquidity benefits help, but the term interest-rate protection may not necessarily be complementary to the overall interest-rate risk profile. 

Floating-rate advances, like the Discount Note Auction-Floater Advance (DNA Floater), allow members to “unbundle” interest-rate and liquidity risks and get the exposures they want and need. In the example below, the member’s liquidity profile is improved due to the one- or two-year final maturities on the DNA Floater, while the interest-rate exposure is comparable to taking a one-month Classic Advance . If liquidity conditions are choppy as the market processes an abrupt shift from hikes to cuts, then it will have been beneficial to have locked in narrow spreads on wholesale funding, while the floating-rate feature allows for funding costs to move down in lockstep with market rates.

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 reach out to your relationship manager for more details.

FHLBank Boston does not act as a financial, accounting, or legal advisor, the content of this article 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. Forward-looking statements: This article uses forward-looking statements within the meaning of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 and is based on our expectations as of the date hereof. All statements, other than statements of historical fact, are “forward-looking statements,” including any statements of the plans, strategies, and objectives for future operations; any statement of belief; and any statements of assumptions underlying any of the foregoing. The words “expects”, “may”, “continue”, “to be”, “will,” and similar statements and their negative forms may be used in this article to identify some, but not all, of such forward-looking statements. The Bank cautions that, by their nature, forward-looking statements involve risks and uncertainties, including, but not limited to, the uncertainty relating to the timing and extent of FOMC market actions and communications; economic conditions (including effects on, among other things, interest rates and yield curves); and changes in demand and pricing for advances or consolidated obligations of the Bank or the Federal Home Loan Bank system. The Bank reserves the right to change its plans for any programs for any reason, including but not limited to legislative or regulatory changes, changes in membership, or changes at the discretion of the board of directors. Accordingly, the Bank cautions that actual results could differ materially from those expressed or implied in these forward-looking statements, and you are cautioned not to place undue reliance on such statements. The Bank does not undertake to update any forward-looking statement herein or that may be made from time to time on behalf of the Bank.