The Takeaway: Fed Walks Inflation/Recession Tightrope in Effort to Cool Economy

June 7, 2022

The Takeaway is a new CoBank publication that provides practical commentary on interest rates and capital markets activities. These insights come from the professionals in CoBank’s Treasury, Capital Markets and Derivatives groups—people who are in the market interacting with customers, investors and other lenders seeking to understand what is driving activity.

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This is Not Your Father’s Inflation; Supply-Side Issues Wreak Price Havoc

The Fed moved aggressively at its May meeting by increasing the federal funds rate 50 basis points to a target of 0.75% to 1%. The Fed said that it expects to make a similar increase at both its June meeting and possibly in July as well.

The Fed’s actions have one goal: reducing runaway inflation, which was 8.3% in April and last seen at this level in the 1980s. But the cause of the current inflation is quite different from the last go-round, according to Kiran Kini, CoBank senior vice president and treasurer. He says current economic conditions have created a precarious tightrope walk for the Fed, which is trying to reduce inflation to its target of two percentage points while not pushing the economy into recession.

“This is not your typical inflation, said Kini. “Inflation normally occurs in an overheated economy where demand for goods is very strong. That certainly is the case now, but this time around the primary issues are on the supply side. 

“There is a shortage of goods across many categories, which initially began with the factory and office closures as well as transportation bottlenecks during the onset of the pandemic. More recently, the resurgence of COVID in China has led to significant new shutdowns in the country, which again slowed exports. The war in Ukraine has also added to inflationary pressures by raising the prices of commodities.”

According to Kini, the Fed has fewer tools with which to address supply-side inflationary issues. 

“The Fed can’t print computer chips and they can’t produce wheat,” he continued. “The only thing they can do is try to reduce demand with higher interest rates to offset the supply shock. But being too aggressive risks triggering a recession.

“A strong labor market makes it even more challenging because strong demand for labor has resulted in higher wages, which supports consumer demand for goods. But the Fed is continuing to tighten financial conditions, which is leading to the equity market volatility we’re seeing now.”

Kini does not believe a recession is imminent because of otherwise strong economic fundamentals. But if the Fed continues its current path—with the possibility of eight more rate hikes—the risk of a recession in 2023 would increase dramatically.

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Interest Rate Sticker Shock Prompts Customer Urgency

According to Eric Nickerson, CoBank’s sector vice president of customer derivatives, customers are responding to the quickly rising rate environment with sticker shock.

“Six months ago, customers could lock in long-term rates at a third of where they are now—sub 1% at year-end versus 3% now,” said Nickerson. “There also is some disbelief with how far the Fed’s tightening cycle may go. Customers are realizing this isn’t your normal humdrum Fed tightening cycle.

"Markets have been pricing in some degree of probability that the Fed would overtighten, then reverse course and end up having to ease rates next year," Nickerson continued. "This is manifested in the shape of the yield curve, which slopes upwards and peaks at about a year from now then slopes back down, creating an inverted curve where longer-term rates are cheaper. We had some customers taking advantage of the shape of the yield curve by doing forward hedges—locking in future longer-term rates but not near term rates."

Nickerson also said that some customers are dealing with the implications and complexity of adjusting their loans and legacy hedges from the LIBOR index to the evolving SOFR standard or another index.

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Secondary Loan Market: Lightly Used, Low-Mileage Leveraged Loans for Sale

Over the past two years, CoBank’s Capital Markets group has steadily expanded its activity in the secondary loan market and has centralized this function under Paul Trefry, head of loan trading and asset sourcing. Trefry and his team have begun establishing relationships with a selected group of institutional investors—collateralized loan obligation funds, mutual funds, hedge funds, pensions, insurance companies and endowments—that are interested in leveraged loan investment opportunities in the agricultural and rural infrastructure marketplace. 

Currently, the Capital Markets group represents CoBank and the Farm Credit System in purchasing certain loans for their portfolios, especially in areas—such as telecommunications—where CoBank has unique authority among Farm Credit banks to operate.

“We are serving in an execution capacity for CoBank relationship managers and portfolio management personnel who determine whether we should sell loans or portions of loans to reduce the bank’s risk exposure,” said Trefry. “But we’re also representing CoBank and many entities in the Farm Credit System in purchasing loans that have the potential to improve our respective loan portfolios. In 2021, we purchased about $1 billion in loans, which was split 50/50 between CoBank and Farm Credit participants.”

According to Clarence Plummer, senior vice president, Capital Markets, his team’s goal is to continue to improve CoBank and the Farm Credit System’s ability to lead large leveraged loan deals for its customers where a trading function is a necessity.

Market Focus

Agribusiness

Market/Industry Anomalies Delay Bulge Facility Pay-Downs, Keep Grain Prices High

In our last issue, we highlighted the increasing demand for working capital loans, or bulge facilities, driven by the recent spike in commodities prices. In normal years, bulge facilities are paid down during springtime, which makes way for a new crop to be delivered to the co-op. 

In the last few weeks, some co-ops have paid down their lines of credit due mainly to shipping/sale to end-users. However, so far in 2022, grain shipping tie-ups and the continued run-up in commodity prices are causing bulge facilities to remain outstanding through June or longer. Some margin money has recently come back to the co-ops on market down days, but that could be short lived given market volatility, e.g., India’s decision to restrict exports. 

The global grain supply is short due to the significant lack of exports from Ukraine and Russia. The supply of fertilizer has also been affected negatively by the war, leading to doubling or tripling of prices. 

Additionally, plantings have been behind in several states because of excess moisture in the north and east, and lack of moisture in the south. Transportation logistics have slowed the shipment of grain the past six months, encompassing trains, trucks and barges. Cost for transportation has been increasing due to labor and fuel costs.

Recent CoBank Capital Markets Activity

Omega Protein | CoBank

Omega Protein

$430M Credit Facilities
Administrative Agent

Caddo Sustainable Timberlands | CoBank

Caddo Sustainable Timberlands

$355M Credit Facility
Administrative Agent

Growmark | CoBank

Growmark

$800M Credit Facilities
Administrative Agent

Communications

Market Volatility Prompts Capital Strategy Rethink

Despite increased market volatility across debt and equity, communication companies have maintained good access to capital markets because their services have become a fundamental part of modern life and business.

However, the market volatility and rising rate expectations have required finance and treasury teams to take a renewed look at their capital strategy:

  • With rising rates, fixed/floating balance has become a higher priority, especially if capital expenditure plans are being financed with floating-rate-delayed draw facilities, which could skew the ratio more toward floating over time as funds are expended.
  • Over the last few years, higher enterprise valuations have supported higher leverage levels. That—coupled with cheap debt—pushed many companies to consider higher leverage options from institutional lenders. With institutional debt having become more expensive lately, finance teams face tougher decisions when reaching for higher leverage versus staying at lower leverage where commercial/Farm Credit debt pricing has remained stable or tightened on a margin basis.

Recent CoBank Capital Markets Activity

Dobson Fiber | CoBank

Dobson Fiber

$170M Credit Facility
Administrative Agent and Lead Arranger

United Communications | CoBank

United Communications

$90M Credit Facility
Administrative Agent

TruVista | CoBank

TruVista

$205M Credit Facility
Administrative Agent

Power & Energy

Beware of Inexperienced Commercial Banks Entering the Project Finance Space

Members of CoBank’s Capital Markets team recently participated in several power and energy industry conferences with a focus on project finance, including Infocast’s Projects & Money Conference, the S&P Global Platts Global Power Markets™ Conference and Infocast’s Solar + Wind Finance & Investment Summit.

A notable takeaway was the presence of many new commercial bank lenders that have appeared at the fringes of the project finance market promoting their active support of renewable (clean) energy. Many sponsors have voiced their concern that in the recent past, some less experienced project finance entrants have been prone to providing incomplete or inconsistent commitments to the industry and sponsors of new projects. Unaccustomed to the structural nuances inherent to project finance, new entrants may unwittingly agree to provide only partial solutions with looser structures or lower pricing than established market participants. Notably, they tend to only commit small amounts to transactions, leaving a financing gap that requires other lenders to fill.

CoBank, a decades-long supporter of renewable and thermal project finance, has a deeply experienced team of professionals in capital markets, coverage, credit, legal and operations. The team is fully fluent in the nuanced aspects of the market and has committed $750 million or more to provide complete solutions with properly priced and structured transactions for sponsor relationships, a task that newcomers cannot fulfill.

Recent CoBank Capital Markets Activity

Puget Energy | CoBank

Puget Energy

$800M Credit Facility
Joint Lead Arranger

Puget Sound Energy

Puget Sound Energy

$800M Credit Facility
Joint Lead Arranger

Tri-State | CoBank

Tri-State

$650M Credit Facility
Doc Agent

DISCLAIMER: The information provided in this publication is for informational purposes only and is not to be used or considered as investment research, a proposal, or the solicitation of an offer to sell or to buy or subscribe for securities or other financial instruments. Companies and transactions referenced in this publication are shown for illustrative purposes only, and the provision of such information is not a recommendation or endorsement in this context. Certain information contained in this publication has been obtained or derived from third-party sources, and such information is believed to be correct and reliable but has not been independently verified. While CoBank believes that factual statements in this publication, and any assumptions on which information in this publication is based, are in each case accurate, CoBank makes no representation or warranty regarding such accuracy and shall not be responsible for any inaccuracy in such statements or assumptions. Note that CoBank may have issued, and may in the future issue, other reports that are inconsistent with or that reach conclusions different from the information set forth in this publication. CoBank is under no obligation to ensure that such other reports are brought to your attention. Furthermore, the information may not be current due to, among other things, changes in the financial markets or economic environment, and CoBank has no obligation to update any such information contained in this publication. This publication is not intended to forecast or predict future events.

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