Next rate increase could come down to a coin flip; commercial bank retrench continues

September 7, 2023

The Takeaway is a CoBank publication that provides practical commentary on interest rates, derivatives and capital markets activities. These insights come from the professionals in CoBank’s Treasury and Capital Markets 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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Interest rates: Fed shifts from inflation-only view to inflation and systemic risk; strong Q3 to preface growth slowdown

After leaving the benchmark federal funds rate unchanged at its June meeting, then raising the rate 25 basis points to a range of 5-1/4 to 5-1/2 in July (there was no August meeting), the financial markets’ eyes are trained on the Fed’s September 19-20 meeting. 

Will they or won’t they?

Perhaps more important than a direct answer to that question, Kiran Kini, CoBank senior vice president and treasurer, believes the Fed’s outlook on risk should be the primary focus.

“The Fed’s view is that we are close to an inflection point where the risks to growth and the risks to inflation are equally balanced,” said Kini. “They're not ready to declare victory on inflation; there's still work to be done. But they also understand that risk to growth and, more importantly, systemic risk to the banking system has gone up. Until now, it's been a single-minded fight against inflation. But they're going to tread very carefully from here and look to balance those two factors.” 

Kini added that while the Fed is keeping its options open for September, it is more likely that they skip a rate increase at the September meeting and leave open the possibility of the next hike for the October/November meeting, continuing on an every-other-meeting cadence. The last Fed meeting of the year is scheduled for December 12-13. If the recent trend of positive data on the inflation front were to continue, it is possible that we have seen the last hike for 2023. 

Meanwhile, increasingly the Fed’s concern is continued robust economic growth.

“Q3 is looking very strong; we're not seeing a slowdown yet,” Kini said. “We could end up seeing GDP growth greater than 3%, which would be the strongest quarter we've had in a long time. 

“But headwinds are picking up,“ he continued. “Student loan debt began accruing again on September 1, higher interest rates are eating into consumer purchasing power, and excess consumer savings from the pandemic are nearly depleted. We expect these factors to result in a slowdown in Q4, but the prospects for an official recession are unclear at this point.”

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Interest rate management: Inverted yield curve continues to deceive

Many economists and market prognosticators have historically looked to the interest rate yield curve as a leading indicator of economic conditions. 

While that notion continues to be argued vigorously, an inverted yield curve—where long-term interest rates are lower than short-term rates has been thought to presage a coming decline in rates, which is often associated with a recession. Advocates of this view say an inverted yield curve has correctly predicted recessions going back to 1955.

Right or wrong, it has not yet been the case this time. As of mid-July, the yield curve has been inverted for more than a year and interest rates have continued to rise while economic growth has remained surprisingly robust.

Eric Nickerson, CoBank’s sector vice president of customer derivatives, says the situation has left some customers feeling oddly bamboozled.

“The expectation that rates would not continue to move up has been telegraphed by the inverted yield curve,” said Nickerson. “The rate environment has misled customers and the market as a whole because there's been an inversion in the yield curve almost since the Fed started tightening in March of last year. 

“Customers had a reason to believe that rates would not continue to go up,” he continued. “But they have, and now they’re coming to a realization that we may never be going back to the near-zero-rate environment we’ve enjoyed for the past 15 years.”

Nickerson says these customer attitudes are resulting in an uptick in hedging discussions as the realization of a new normal going forward settles in.

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Capital Markets: Trend toward automation begins to take hold

While the markets for equities and bonds have embraced automation for decades, the secondary loan market has remained roughly in the stagecoach era. That’s beginning to change, according to Clarence Plummer, senior vice president, Capital Markets at CoBank. And it’s about time.

In the broader marketplace, Plummer points to the beginnings of a loan marketplace, such as PNC Asset Exchange, which is a new online loan resource and marketplace for financial institutions, recently launched by PNC FIG Advisory, part of PNC Capital Markets LLC.

“PNC Asset Exchange gives us an idea of how an automated loan market will eventually work,” Plummer said. “All of the things we’ve been doing individually—calling people, emailing them, transmitting documentation—will all take place in an online marketplace, much like the NYSE or NASDAQ.

“Investors will be able to go to a loan exchange, look at the documentation, and they'll decide yay or nay, and then they'll put in their orders, which we will fill at certain levels,” he continued. “Now, the marketplace is only for financial institutions. But eventually it will function similarly to how you buy stocks either on an app or through your broker, and either you or your broker will monitor your position.”

Internally at CoBank, Plummer pointed to the SyndTrak automation project, which automated the process of providing quarterly loan documentation to investors.

“Syndtrak automation eliminated hours of very dull and tedious work to meet our requirements for investor disclosure,” said Plummer. “The fact that this was a manual process was a severe misuse of resources. It took a cross-functional group across the bank to get it done, but it’s saving hours upon hours of time and effort.”

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