| 
Robert Segal
As expected, the Federal Open Market Committee (FOMC) decided to maintain the target range for federal funds at 0.25 percent to 0.50 percent following a two-day meeting last month in Washington. The committee said the pace of improvement in the labor market had slowed since the April meeting, as job gains diminished. While it acknowledged that growth in economic activity appears to have picked up, the FOMC is still concerned that business fixed investment has softened.
The median forecast of policy makers remains at two quarter-point hikes this year, though the number of officials who see just one increase rose to six from the March forecast. The central bank reiterated that interest rates are likely to rise at a gradual pace, without referring to the next meeting in July or any other date for a rate increase.
In the press conference following the announcement, Fed Chair Janet Yellen said the referendum in the U.K. on whether to remain in the European Union was a factor in the decision to hold steady. Voters in Great Britain decided on June 23 to leave the EU in what analysts called “Brexit.”
In recent testimony before Congress, she suggested the committee would watch for whether, rather than when, the U.S. economy shows clear signs of improvement before hiking rates. There’s a “sense that maybe more of what is causing this rate to be low are factors that won’t be rapidly disappearing but are part of a new normal,” Yellen said, pointing to factors such as lagging productivity growth and an aging population.
Fed officials now project the median federal-funds rate target at the end of 2017 will be 1.625 percent, down from an earlier forecast of 1.875 percent. They predict the rate at 2.375 percent at the end of 2018, lower than the 3 percent they called for in March.
At this time, markets place the chance of a rate increase by year-end at 10 percent, down from 65 percent after the Fed’s April 27 meeting. The yield on the benchmark 10-year Treasury note traded recently at 1.40 percent, compared with 1.85 percent at the end of May. Further in on the curve, the five-year note currently yields 95 basis points.
Consider Quality Vs. Quantity In A Portfolio
In this environment, it’s helpful to revisit the institution’s investment process. Some investment officers use a “shotgun” approach for selecting securities. Based on the recommendation of a few brokers, the investment officer will often buy the “cheapest” bonds available, regardless of the composition of the existing portfolio. This method can lead to a portfolio with sub-optimal allocation; less diversification means more risk on the balance sheet.
A more effective approach is to develop an investment plan which takes into account the institution’s balance sheet and business plans. The plan should integrate with the asset-liability position, with the goal of increasing income and reducing interest rate risk over time. When putting together the strategy, the institution should set targets for the following areas:
- Sector allocation
- Portfolio duration
- Projected cash flow
- Price volatility
Each institution’s balance sheet is comprised of a unique asset mix. Some are heavily weighted in long-term, fixed-rate residential loans. In a falling rate environment, however, the loans could shorten dramatically, providing significant cash flow. On the other hand, commercial banks usually make a large number of floating-rate C&I loans. These assets provide higher levels of income in a rising rate environment, but expose the institution to “income-at-risk” in a stable or declining rate scenario.
For the mortgage lender, unexpected changes in the market may cause significant volatility in cash flow. When rates rise, the loans extend, providing minimal funds to redeploy at higher yields. Falling rates lead to faster prepayments, and those funds must be put back to work at lower levels. Here, an allocation to short- and intermediate term bullet securities, such as agencies and corporate bonds may be appropriate, since the cash flows are known in advance. As the bonds season and roll down the curve, the price volatility declines, offsetting the potential economic valuation impact of 30-year mortgage loans.
Municipal bonds may be appropriate for the commercial lender. Long-term municipals provide high levels of current income, boosting earnings should the environment remain unchanged. They provide call protection for periods of up to ten years, enabling the institution to hold on to the yield for some time. The risk weighting (20 percent for general obligation bonds) serves as a buffer against the 100 percent risk weight of commercial loans.
One of the most important roles for the investment officer is to manage the institution’s asset allocation strategy. A number of academic studies have shown that sector allocation is a big determinant of outperformance. With an effective investment plan, the institution should be able to improve income over the long run while minimizing unwanted surprises.
Robert B. Segal is president of Atlantic Capital Strategies Inc., an investment advisor located in Bedford. He can be reached at bob@atlanticcapitalstrategies.com.
