Pub. 8 2020 Issue 1

www.uba.org 12 T he U.S. economy remains strong, but there are signs of late-cycle fatigue. The Federal Reserve Bank of Atlanta expects real GDP to ad- vance 1.9% in the third quarter. If sustained, this would represent a marked deceleration from 2018’s growth rate of 2.9% and the Trump Administration’s goal of 3.0%. U.S. businesses, facing steep tariffs and anticipating weaker demand for goods and services, are starting to curtail investment. Since corporate sales fund workers’ wages, consumer spending could slow in turn. It’s tough to envision right now because con- sumers are confident and spending briskly as the stock market reaches all-time highs. Unfortunately, confidence is an emotion, not a fundamental data point. Last year’s fourth quarter reminded us that consumer sentiment can turn on a dime. We also note that the Treasury yield curve, as defined by the spread between the yield on the three-month bill and the 10-year note, has been inverted for several months. According to the Federal Reserve Bank of Cleveland, “The rule of thumb is that an inverted yield curve indicates a recession in about a year, and yield curve inversions have preceded each of the last seven recessions (as defined by the National Bureau of Economic Re- search).” Based on the three-month/10- year spread for the week ending Aug. 23, the Federal Reserve Bank of Cleveland assigns a 44.1% probability of recession within the next 12 months, up from 35.4% in July. Recession is just about a coin toss. Against this backdrop, Fed Funds Fu- tures, which have done a better job pre- dicting Federal Open Market Committee actions than the policymakers’ own Dot Plot, are pricing in four rate cuts between now and year-end 2020. This stimulus could prolong the economic cycle, which might translate into higher demand for loans and contain credit costs near-term. However, unless the yield curve steep- ens — unless inflationary expectations percolate across the curve and the bid for safe-haven assets weakens — bank net interest margins and earnings will likely remain under pressure. In such a challenging operating environ- ment, banks must stay vigilant and focus on the fundamentals. BEST PRACTICES FOR CREAT- ING FRANCHISE VALUE LATE IN THE ECONOMIC CYCLE Strengthen your core. We want better banks, not just bigger banks. Specifically, focus on improving core pretax, pre-provision return on assets (core PTPP ROA; core earnings excludes nonrecurring accruals, such as securities losses and one-time gains). Core PTPP ROA, to control credit volatility and tax strategies, exposes a bank’s true earnings power. We believe that at this point in the cycle, focusing on return on assets (ROA) will drive a higher return on equity (ROE) over the long run. Align incentives with desired outcomes. Consider incorporating core PTPP ROA into your short- and long-term incentive plans. Doing so creates space for for- ward-looking, franchise-enhancing tac- tics (a securities portfolio optimization, liability restructure, lease termination, or branch rationalization, to name a few). Also, make sure that the weights assigned to loan and deposit origination, fee gen- eration, and credit look-backs reflect your tactical objectives and risk tolerance. Weaponize the inverted swap curve to reduce funding costs. Recent simplifications to hedge accounting have made hedging much more viable for community banks. Vari- ous off-balance sheet strategies are worth exploring due to these changes and the inverted LIBOR swap curve. If the inverted Treasury curve is your nemesis (as it relates to asset yield erosion), then the inverted swap curve should be your best friend (as it relates to reducing funding costs). One such strategy is to use a pay-fixed swap to hedge the rollover risk of short-term funding. This creates synthetic term rate protection at a meaningfully lower cost than a comparable term FHLB advance or brokered CD. This same strategy can also make prepaying above-market FHLB advances economical. Unfortunately, if the forward swap curve holds its current shape, the inversion that anchors these funding strategies will evaporate over the next 12 months. Bottom line, it’s time to firm up your funding needs and put pen to paper. Create shelf space for higher funding costs through a securities portfolio optimiza- tion. Take advantage of the rally in the LATE IN THE CYCLE, IT’S BACK TO BASICS FOR BANKS . . By Scott Hildenbrand and Matthew Forgotson