Interest rates are near the top of the range again, creating an investment opportunity
Market expectations were initially projecting it to be a better year for fixed income investors, as many economists thought we would be in a recession by now or one looming right around the corner and interest rates would be lower. Long term rates are now slightly higher than where they started the year, and the yield curve remains inverted. There was a brief period towards the end of the first quarter when it seemed the FOMC may be getting closer to the end of their tightening campaign. However, a resilient job market with elevated inflation has continued to keep the Federal Reserve in play for additional rate increases after a unanimous decision to pause at the June meeting. Since the June FOMC meeting, Powell has commented that interest rate cuts are not on his radar just yet, and by raising the terminal rate suggests that interest rates may stay higher longer than the markets were initially hoping.
The investment environment for the banking community is currently pressured with elevated funding costs and limited excess cash, making the primary focus around borrowing capacity and evaluating alternative borrowing structures in Callable Advances as a means to increase net interest margin for the balance sheet.
Interest rates have recently risen in anticipation of another rate increase at the July meeting. The 10-year Treasury is now higher than where it started the year, and depending on upcoming economic data, could remain near 4.0% or even higher. Under this scenario, we see this as an investment opportunity. Investor demand is light this year, driven by liquidity constraints and the liquidations of Silicon Valley Bank and Signature Bank’s investment portfolio that resulted in wider spreads across Agency products.
Under the assumption that additional borrowing would likely be needed to fund any new investments, the Investment Committee believes AAA securities that can immediately be accretive to earnings near 6.0% without extending out the yield curve look attractive. Even if short-term rates increase at the next two policy meetings by 50 basis points, current investments at 6.0% would still be accretive to funding costs. The likelihood of additional rate increases should impact the unemployment rate and ultimately slow the economy over time. Although the Agency Mortgage market can offer price appreciation, the current yield of 5.70% does not offer enough yield in comparison to current overnight funding costs.
As a result of the longer end of the yield curve pricing in a recession, bullet-like securities on the 5 and 10-year part of the yield curve only offer yields just above 5.0% and would need rate cuts before becoming accretive to earnings. However, with the recent interest rate volatility a Callable Agency can offer a yield near 6.0%. It is likely that the bond will be called away when the lockout period expires, but under the scenario that it was funded with overnight borrowings it would have increased net interest margin along the way.