cfa society dayton january 8, 2019 kuntz presentation 1... · • investment grade spreads measure...
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The Federal Home Loan Bank CFA Society Dayton
January 8, 2019
Darren KuntzMichael Spencer
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Darren Kuntz has worked in the banking industry since 1995. His primary roles prior to joining the Federal Home Loan Bank of Cincinnati focused on interest rate risk and fixed income portfolio management. Darren joined the Federal Home Loan Bank of Cincinnati in 2003 as an Assistant Portfolio Manager in the Treasury department. In 2018, he was promoted to First Vice President, Assistant Treasurer and is responsible for balance sheet management. Darren received his Bachelor of Science in Finance from Northern Kentucky University and a Master of Business Administration from the University of Cincinnati.
Michael Spencer has worked in the banking industry since 2009. His primary roles, prior to joining the Federal Home Loan Bank, focused on the fixed income markets and interest rate risk. Michael joined the Federal Home Loan Bank in 2015 as a Financial Analyst in the Marketing department developing advanced level financial and market for FHLB Members. In 2016, he was promoted to Insurance and Sales Officer. In his current role, Michael is the primary relationship manager for the FHLB Insurance Company members assisting with funding strategies and balance sheet analytics. Michael received his Bachelor of Business Administration in Finance from the University of Notre Dame.
Darren Kuntz Michael Spencer
FHLB Cincinnati
Market Update
FOMC Projected Rate Increases• FOMC raised the Fed Funds Target Range 3 times in 2017, followed by 4 increases in
2018.• FOMC has only increased the Interest paid on Excess Reserves (IOER) by 20 basis
points each of the past two interest rate increases– De-couples the top end of the Fed Funds Target Range from IOER– Effective Fed Funds Rate and IOER are converging– Effective Fed Funds Rate and IOER remain near the top of the Target Range.
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0
0.5
1
1.5
2
2.5
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Federal Funds Bottom of Taget Effective Rate IOER Top of Target
2.10%
2.20%
2.30%
2.40%
2.50%
2.60%
2.70%
2.80%
2.90%
January-19 April-19 July-19 October-19
Fed Funds Futures Implied Rates
9/28/2018 12/31/2018
Federal Reserve Balance Sheet• Federal Reserve continues to reduce the size of its balance sheet by allowing
Treasuries and Agency MBS to mature without reinvestment.• Over $400 Billion has matured since the beginning of 2016.• Combined with rate increases, FOMC is reducing accommodative monetary policy.
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$3,800
$3,900
$4,000
$4,100
$4,200
$4,300
$4,400
$4,500
$4,600
1/4/2016 4/4/2016 7/4/2016 10/4/2016 1/4/2017 4/4/2017 7/4/2017 10/4/2017 1/4/2018 4/4/2018 7/4/2018 10/4/2018
Bill
ions
Federal Reserve Total Assets
Inflation In Line?• Inflation remains near FOMC’s target of 2.0%.• 5 year real yields moved into negative territory in 2010, remaining there for much of
the next 5 years.• The 5 year real yield has been positive for all of 2018.
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-3.00
-2.00
-1.00
0.00
1.00
2.00
3.00
4.00
5 Year Real Yields5Y T-note - 5Y TIP Implied Inflation
Inverted Yield Curve• Treasury Curve has recently inverted, a typical sign of an upcoming recession.• 5 year Treasury yield fell below 3 year Treasury yield in early December. It has since
returned to higher level.• Spread between 10 year Treasuries and 2 year Treasuries has narrowed from over 50
basis points, to less than 20 basis points in the last 12 months.
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1.001.201.401.601.802.002.202.402.602.80
2YUST
3YUST
5YUST
7YUST
10YUST
Treasury Yield Curve
12/31/2018 12/29/2017 12/30/2016
(1.00) (0.50)
- 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00
Dec
-03
Dec
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Dec
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Dec
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Perc
enta
ge P
oint
s
Yield Curve Steepness
5Y UST - 2Y UST 10Y UST - 2Y UST 10Y UST - 3mL
Credit Stress Metrics• Investment grade spreads measure the difference between the yield on US Treasury bonds
and debt of lesser quality such as corporate bonds. The IG CDS Index measures the cost of the credit default swaps on investment grade entities.
• Investment grade spreads have widened materially from the start of the year driven by trade concerns, higher corporate leverage, a potential slowdown in global growth, and tightening of monetary policy by the Federal Reserve
• Investment grade spreads typically track stock market performance and are often viewed as a leading economic indicator.
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1/4/2018 2/4/2018 3/4/2018 4/4/2018 5/4/2018 6/4/2018 7/4/2018 8/4/2018 9/4/2018 10/4/2018 11/4/2018 12/4/2018
Investment Grade CDS Index
Bank Asset Sensitivity
Net Interest Spread Analysis• Fifth District Bank and Thrift members remain asset sensitive, to a small degree.
– Yield on earning assets has increased 36 basis points since the beginning of the change in monetary policy.– The cost of funds has risen 23 basis points over the same time period.– Result is Net Interest Spread increase of 13 basis points over the last 11 quarters.
• Increase in spread of 13 basis points is significantly less than the over 200 basis points of short term rate increases pursued by the FOMC.
• Short term liabilities (deposits) are repricing in line with long term assets (loans) muting the increase in Net Interest Spread– Flattening yield curve is detrimental to net interest spread.
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0.00%0.50%1.00%1.50%2.00%2.50%3.00%3.50%4.00%4.50%5.00%
Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017 Q2 2017 Q3 2017 Q4 2017 Q1 2018 Q2 2018 Q3 2018
All Fifth District Banks and Thrifts
Yield on Earning Assets Cost of Funds Net Interest Spread Fed Funds Target Range (Top)
Banks, Thrifts, S&L Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017 Q2 2017 Q3 2017 Q4 2017 Q1 2018 Q2 2018 Q3 2018Yld. on Earn. Assets 4.16% 4.17% 4.17% 4.14% 4.14% 4.21% 4.28% 4.30% 4.31% 4.42% 4.52%Cost of Funds 0.51% 0.51% 0.52% 0.51% 0.50% 0.52% 0.55% 0.57% 0.59% 0.65% 0.74%Net Int. Spread 3.65% 3.66% 3.65% 3.63% 3.63% 3.69% 3.73% 3.73% 3.72% 3.77% 3.78%
Net Interest Spread Drivers• Most asset yields are little changed over the last 11 quarters.
– Yield on loans has risen 17 basis points during this time period, compared to Fed Funds increases of 200 basis points.– Yield on Securities has fallen 14 basis points since the FOMC began increasing the Fed Funds Target Range, and
securities balances as a percentage of total assets has declined.– The increase in Net Interest Spread is being driven entirely by increased loan yields and volumes.
• The cost of interest bearing deposits has increased 27 basis points over the trailing 11 quarters.• Deposit betas continue to lag the FOMC, but have increased rapidly in 2018, at times outpacing loan betas.
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0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017 Q2 2017 Q3 2017 Q4 2017 Q1 2018 Q2 2018 Q3 2018
All Fifth District Banks and Thrifts
Yield on Loans Cost of Int. Bear. Dep. Yield on Securities Fed Funds Target Rate (Top)
LIBOR Reform
What is LIBOR?
• LIBOR (London Interbank Offered Rate) started In 1986 as a standardized rate for many types of financial instruments
– Currently utilized for derivatives, business loans, securitizations, and debt issuance
– Intended to represent the rate at which banks can borrow money from each other (unsecured interbank funding)
• Maturities from overnight to one year submitted by panel banks (approx. 20 of the largest banks in the world)
• FHLB Cincinnati issues Advances, purchases investments, executes derivatives, and issues debt indexed to LIBOR
• LIBOR is also the benchmark curve for valuing the balance sheet
• Unregulated until September 2012– Now regulated by the Financial
Conduct Authority (FCA) in the U.K.– Administered by the Intercontinental
Exchange (ICE)
• Approximately $200 trillion of global financial contracts are indexed to US Dollar LIBOR with $350 trillion in total contracts tied to LIBOR
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Why is LIBOR being reformed?• LIBOR is becoming less relevant and trusted
– Many contributing banks were found to have been manipulating LIBOR– Post crisis financial reform has decreased the amount of unsecured interbank funding (on which LIBOR is based)
• Current overnight Fed fund market trading volume of $50 to $60 billion per day (down from $125 to $150 billion pre-crisis)
• Banks are required to fund themselves with a larger portion of long-term debt– There is a material subjective component to daily LIBOR submissions
• Alternatives have been developed that are gaining momentum
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3/6/2016 6/6/2016 9/6/2016 12/6/2016 3/6/2017 6/6/2017 9/6/2017 12/6/2017 3/6/2018 6/6/2018 9/6/2018 12/6/2018
Daily Fed Funds Volume
When is LIBOR being reform?
• FCA (LIBOR regulator in U.K.) announced in July 2018 the potential to declare LIBOR unfit for use after 2021
– July 2017 FCA announced submitting panel banks will not be required to quote LIBOR past 2021
– Benchmark regulation in the E.U. requires a reference rate to be representative of the market
• The capital markets will strongly influence the timing as robust alternative reference rate markets evolve (swaps, futures, debt etc.)
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2008/2009 –LIBOR manipulation reported to Fed and financial media
2012/2013 –LIBOR regulator FCA is formedThe Wheatley Review calls for LIBOR reform
2014 –ICE becomes LIBOR administrator Financial Stability Board issues report on reforming interest rate benchmarks
2017 –FCA states that panel banks are not required to submit LIBOR post 2021
2018 –Prudential Regulators issue roadmap to alternative reference rate transition Fed publishes SOFR SOFR indexed debt issued
LIBOR Reform Timeline
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Secured Overnight Funding Rate (SOFR)• SOFR (Secured Overnight Financing Rate)
– Rate has strong support from the Prudential Regulators through the Alternative Reference Rate Committee (ARRC) of the Fed
– Rate is set daily based on overnight Treasury repurchase agreement rates (secured borrowings for financial institutions) –transparent and transaction based
• Financial institutions include securities dealers, banks, REITS, insurance companies, and GSEs• Overnight Treasury repurchase agreement trading volume $800 to $900 billion• Results are “trimmed” to eliminate duplicates and “special” trades
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0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
1/4/
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3 Month LIBOR Vs 3M Avg SOFR3M LIBOR 3M Avg SOFR Spread (RHS)
SOFR Debt Issuance
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$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
$14,000
2018
Mill
ions
2018 SOFR Debt Issuance
Fannie Mae Federal Home Loan Banks Freddie Mac Other Issuers
What is FHLB Cincinnati watching?
• Financial market liquidity for LIBOR, OIS, and SOFR indices
• Evolution of financial contract language – fallback language, coupon lockout, average coupon rate
• Market consensus on how to treat legacy investments and derivatives– When to trigger LIBOR to SOFR– How to adjust legacy LIBOR rates
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Thank You