Pub. 7 2019 Issue 4

www.uba.org 22 By Brad Spears I n July, the Federal Reserve Open Mar- ket Committee (FOMC) cut the federal funds rate by 25 basis points (bps). This rate cut comes less than a year after the last in a series of nine rate increases instituted by the FOMC that began in December 2015 and ended in September 2018. From December 31, 2015 to Septem- ber 10, 2019, the two-year Treasury yield has increased 61 bps. Three and six-month Treasury yields have increased 179 and 140 bps, respectively. Over a similar time period, the 10-year Treasury yield has contracted 27 bps. Due to the differing magnitudes of the increases along the short-end of the curve and yield contrac- tions in the long-end of the curve, the yield curve has flattened significantly and remains inverted between the two-year and five-year points. This is in itself very troubling because an inverted yield curve is typically a harbinger of an impending economic slowdown or recession. Historically, the yield curve has been an accurate leading indicator for economic conditions. Learning to interpret and the yield curve’s slope and shape can assist portfolio and balance sheet managers in establishing investment, loan portfolio and liability strategies to maximize re- turn and minimize interest-rate risk. The current yield curve shape should force asset liability managers to be particularly vigilant in managing the asset side and li- ability base duration. In particular, given that most bank balance sheets purport an asset sensitive risk profile, the prospect of a sustained rates falling scenario can have severe financial implications. Many prudent investment and asset-lia- bility managers use “duration” to mea- sure weighted average time of portfolio cash flows and the aggregate level of price risk harbored in their investment or loan portfolios. Duration — the method used to estimate both of these issues — can also be used to value your certificate and wholesale funding portfolios. British Economist Frederick Macaulay first introduced the concept of duration in 1938. He sought to create an instrument that would allow the prudent manager to estimate the timing of cash flows (princi- pal and interest payments) from fixed-in- come bonds. He understood the premise that a two-year bullet investment, which pays semiannual interest, has an actual maturity of less than two years. Macau- lay’s duration model provided a way to MONITORING ASSET AND LIABILITY BASE DURATION IS KEY TO EFFECTIVELY MANAGING INTEREST RATE RISK