David Austin Jul 23, 2014

Improving Fixed Income, Courtesy of the Fed

Federal Reserve chairwoman Janet Yellen recently indicated in no uncertain terms that it was not the Fed’s intention to raise interest rates for the foreseeable future. Citing a lack of confidence in interest rates as the most effective tool to counter existing “financial excesses” among financial institutions, Yellen indicated that when interest rates do inevitably begin to increase, it will be in response to a strengthening of the United States economy rather than as a countermeasure to what is happening in the markets. Most industry analysts agree that any rise in rates will not occur until sometime in 2015, at the earliest, or even 2016.

So, what should be the response of bankers to this increased level of clarity about the Fed’s intentions relative to interest rate change?

In a low interest rate environment, the instinct of many bankers is to essentially go into “lock down mode” and sit on their banks’ assets until rates begin to adjust upward. Strategically, this is a mistake as this bunker mentality leaves too many revenue opportunities on the table. Eighteen basis points on cash today does not pay the bills and bankers are creating more income today from investments in the bond portfolio as loan demand still lags in many markets.

Yet, even in today’s market, there are still opportunities for bankers to generate meaningful revenues if they know where to look. That search should start within their own vaults, or the funds that they have sitting at the Fed to meet reserves. Bankers should be actively mining their balance sheets, searching for any underperforming assets and leveraging daily strategies to generate incremental levels of revenue from the fixed income market.

Retail Sweep

A proven approach to maximizing assets is through deposit reclassification, a retail sweep program that reclassifies a portion of a financial institution’s transaction accounts as savings deposits for reporting purposes. In effect, this program reduces the institution’s reserve requirement below cash holdings and recovers a low earning balance back to the bank for investment opportunities.

Funds maintained at the Fed behave as an illiquid asset and, once recovered, represent usable capital to fund loans to local businesses and individuals within the communities that the financial institutions serve. For example, reclaimed funds can be lent through non-brokered certificate of deposit programs and can then be sold for almost any time period at a higher rate than the Fed Funds rate. These deposits are insured up to $250,000 by the FDIC and are not considered brokered deposits by regulators. Additionally, there is the residual benefit of the funds staying local to the markets that generated the deposits. According to a March 13 webinar titled “The Rate Environment and Your Bank” hosted by SNL, securities for U.S. Banks and Thrifts have grown to approximately 21% of bank assets from just 16.6% between the fourth quarter of 2009 and the end of 2013. This indicates that financial institutions are tapping into other fixed income sources to generate income.

Assuming interest rate change is not on the horizon until 2016, another strategy on reclaimed funds is in fixed income. The Fed in this scenario has in essence anchored interest rates at 25 basis points on the short side of the yield curve, which is a signal that the market  expects interest rates to remain lower for longer. The Fed has communicated its intention to exit the bond buying business (tapering) in October and this signal has pushed longer term Treasury yields higher. The market sees this as a sign that the Fed is relinquishing its control on the long side of the yield curve.

The shape of the yield curve has steepened with a greater spread in yield between short-term Treasury investments and long-term Treasury investments. A steeper yield curve typically signals an improving economy and rising inflation expectations. This potential two-year anchor provides an opportunity for bankers to invest on the yield curve and take on a longer duration investment to pick up on absolute yield and total return. Consider the five-year Treasury, now at 1.66%. Investment managers are in a position to use current Fed guidance to move on the yield curve and “roll-down” the curve as we approach future rate change to improve absolute and total return while adding interest rate protection. Deposit reclassification enables bankers to tap into investable funds that were once frozen at the Fed earning marginal rates of return.

As the Fed manages its own balance sheet by unwinding its asset purchases from the U.S. Treasury, with an anticipated exit in October, a possible strategy to soak up the liquidity created will be to increase the interest rate paid on excess reserves maintained by financial institutions. A resulting effect of this action of increasing interest rates on excess reserves is an incentive for the bank to deposit money back with the Fed. Under this scenario, a bank under the most conservative of strategies is rewarded for reclaiming its required reserve balance for investment back to the Fed as an excess reserve for higher returns than given as a required reserve.

Historically, it has always been difficult for bankers to peg future interest rate change and timing. The reality is that financial institution chief financial officers are better equipped to do so today based on the Fed’s forward guidance and qualitative assessment for rate change policy. Armed with that level of insight, bankers can take strategic steps now to better identify opportunities to generate additional, incremental revenues while simultaneously positioning themselves to better capitalize on interest rate increases when they do eventually occur.

Mr. Austin is vice president of Atlanta-based CetoLogic, a provider of software and analytics solutions for financial institutions and retailers. He can be reached at daustin@cetologic.com.

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