MARKET UPDATE Final Jeopardy


Don’t bet the bank! When I first started trading bonds 15 years ago, I often heard the industry veterans use that phrase. In the bond trader’s chair, one should be unafraid to bet big when youn skew is in


think thek risk-reward


mindset can be quite different from the banker’s chair. Although


n your favor. I have learned that h both occupations


require a great degree of risk management, the risks differ and the strategic repositioning to address the risks takes place at very different velocities. Community bank balance sheets


have generally been positioned around the assumption that rates would continue to drift upward. Very short-term rates have remained stable, but tenors ranging from two years to 10 years are about 100 basis points lower than early November. The framework of rate


f assumptions at Q3 2018


Asset/Liability Committee meetings likely gave little credence to potential for such a violent repositioning in rates and outlook. Given all of the information we have


available as market participants, it is curious that we can so often misjudge the aforementioned risk-reward skew. As rates hit their recent peaks in early November 2018, expectations were for two more FED hikes for 2019. Father time has led many to forget how effective their blunt rate tool can be. FED tightening works, the effects are lagging, and 225bps later, the markets started to worry. That worry was catalyzed by (in no particular order): trade disputes (Canada,Mexico, China), a mature eco- nomic cycle, moderated tax cut benefits, United Kingdom vs. EU, Italy vs. EU, domestic housing price disinflation, record levels of corporate borrowing and lackluster inflation and wage growth. None of those particular factors suddenly appeared by the time November rolled around, yet the move in the markets was seen as a great surprise. Managing expectations is a large part of what the officialdom at the FED does. Many of the FED economists subscribe to


f


the notion of the Phillips Curve, which links decreased unemployment with ris- ing wages. Theoretically, the rising wages eventually put pressure on overall pricing, and that in turn, drives the inflation rate higher. Of the last 48 monthly readings, the unemployment rate has been at or below 5 percent all but four months. I think the continued adherence to certain policy drivers such as the Philips Curve is poor message management on the part of those dictating inflation expectations and monetary policy. Poor message management from policy makers can certainly lead to poor risk management. Another related example is the often mentioned and missed 2 percent target on inflation—the messaging from the FED has not changed and that can lead to volatility due to difficulty balancing the risks to the economy and markets with the message from the FED. Speaking of volatility, the most recent


rates tantrumhas occurred as the European Central Bank, Bank of Japan,


f Peoples Bank


of China (and still to a degree the Federal Reserve) enacted extraordinary policies to facilitate growth. I think we can say we have hit the point of diminishing marginal returns for these programs when market reaction to the FED’s new balance sheet target size of $3.5


f trillion is a collective


shrug. The global central banks have been ultra-accommodative for years, yet we do not have a coordinated and sustained global growth boom. If thef


developed world


cannot sustain growth given the friendly monetary backdrop, what does that portend with accommodation scaled back? The market expectations for interest


rates forced many community banks to position balance sheets to address the risks of higher


f


largely in part by (stale) messaging from the FED, eschewed the serious probability for a rate rally. The real danger to bank profitability is in fact lower rates. Given all


rates. Those expectations, driven


ARTHUR W. SPELLMEYER, IV President, First Bankers’ Banc Securities, Inc.


awspellmeyer@FBBSinc.com


Missouri Kansas


Nebraska


888-726-2880 866-530-2846 888-726-2880


Oklahoma 405-638-3248 Texas


512-761-3931


of the resources that go into research and commentary to judge the markets, we still misjudge the voracity and timing of events like the rally in rates over the last six months. FBBS is now able to help with Interest Rate Risk reporting and Asset/Liability Management. Over the last two years, we have built an in-house strategies team and equipped them with the software to address and evaluate bal- ance sheet risk in all types of scenarios. A mature recovery cycle, imperfect informa- tion and volatile markets contribute to the notion that we are nearing an inflection point. As we head into this round of “Final Jeopardy”, it will be helpful to know the risks associated with the category before thinking about betting the bank.


MIB Community BANKING 5


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