Recapping the FOMC Meeting & What it Means for the Bond Portfolio
This week we sit down with Todd Davis and Todd Patrick from our fixed-income group to recap the recent FOMC meeting and discuss it’s implications for the bond portfolio.
The views, information, or opinions expressed during this show are solely those of the participants involved and do not necessarily represent those of SouthState Bank and its employees.
Intro: Helping community bankers grow themselves their team and their profits. This is The Community Bank Podcast.
Caleb Stevens: Well, hey everybody and welcome to Episode 51 of The Community Bank Podcast.” Tom, we are 51 shows.
Tom Fitzgerald: Wow headed to the centennial number and in no time.
Caleb Stevens: Headed to the centennial number in no time, we are about an episode away but a week away from having our soundboard repaired. So, you and I are huddled around this little old microphone that I used to use in college back when I ran a podcast show for the Terry College of Business. So shout out to UGA and the Terry college but we are going to talk today about the investment portfolio, the economy, and sort of piggybacking off of what we did with Joe Keating last week getting an economic update, but want to get practical this week and talk about what that means for the bond portfolio. And Tom, we just had the recent FOMC meeting so we’re going to recap that as well.
Tom Fitzgerald: That’s right, we had the FOMC, and we had second-quarter GDP so a lot of first-year information comes into the market this week. So, we thought it would be an appropriate time to kind of get back are our two Todd’s, Todd Patrick and Todd Davis, and give them a chance to give us their thoughts on the investments we did this about a year ago and is one of our most listened-to programs. So, they’ve just got a wealth of information and they’re very articulate and explaining it reasonably that everybody I think will be able to understand. So, I think it’s going to be a great program for our listeners.
Caleb Stevens: And on that note, tell us real quick about your latest bond portfolio trends analysis, we do bond accounting for I know, like 130 banks or so and you write up a report that sort of analyzes the aggregate trends that you’re saying, tell us more about that?
Tom Fitzgerald: Well, you’re right, it’s that we account for about 130 banks, it’s about 14 billion in power, I think now. And so, most bankers like to know what everybody else is doing and so this is sort of a way to do that. So, what we do is compile all of those portfolios into one and we get averages out on book yield on the duration on unrealized gain or loss, and just the trends and all of that as well as what they’re investing in as far as the individual sectors like mortgage banks and Munis and agencies. So, it’s a really good snapshot again, of what the typical Community Bank portfolio is doing and how the portfolio is performing and again, it’s just a two-pager so it’s a quick read and I think it’s pretty valuable information for most portfolio managers.
Caleb Stevens: It’s a quick read, but I’ve had CFOs, put it in their board packages before board meetings to have, given the board kind of some insight on what other community banks are doing in the bond portfolio. Instead of getting that go to southstatecorrespondent.com/bond report, you can fill out a little form on that page, and we will send it your way. So check it out and enjoy this episode with Tom Fitzgerald and Todd Patrick and Todd Davis.
Tom Fitzgerald: Guys, welcome back, Todd and Todd, Todd Patrick Todd Davis, this is sort of like getting the old band back together, isn’t it?
Todd Davis: It is team Todd, that’s right. Thanks for having us on our show.
Tom Fitzgerald: And it’s good to see you guys on I was still with the kind of the work from the home thing as we kind of see each other sort of fleeting moments so it’s good to get you all back in one room together. In this episode, we’re sort of doing a little kind of an old tech approach we’ve got one microphone and we’re all sharing it. So, if for some sound quality issues, that’s the reason behind it but anyway, these episodes we did this about a year ago, I think with the two of you, and it was one of the most listened-to programs. And so we wanted to kind of revisit, where we are this year, with the economy and the investments and also the Fed. And let’s just kick it off, because I know the listeners are eager to hear what you guys have to say and speaking to the Fed.
We’re recording this right after the July fed meeting and from my perspective, and I’ll get your guy’s impressions too. From my perspective, it was funny it was the statement was a little bit less soft and tone than I was expecting. I was expecting they would kind of acknowledge the Delta Variant and kind of the rise in cases there and kind of take back some of the confidence or hawkishness they had in June and they didn’t. But then Powell’s press conference to me was a little bit he kind of took on that dovish tone, and kind of expressed that it looks like at least from a rate perspective. He’s going to be accommodative well into 22 and if not into 23 as well and I think why they’re going to start talking tapering probably later this year. I still think from a rate perspective, we’re looking we’re still looking down the road a while before we see the first rate hike. So Todd, can you want [cross-talking 04:51] on that?
Todd Patrick: Yes, no. It’s very much like you, I thought it might come across as a bit more dovish. I’m just kind of enjoying watching this disjointedness between the market and the Fed. I mean, we start the year with the market being scared to death of inflation in the feds like guys it’s all right. In June, the Fed goes, inflation could be a problem and the market excels and now the bond market comes rallies and not paying attention. And that the market scared to death of Delta, in that case, is coming in and the feds kind of blowing it off it’s like, just how different they’re seeing the world from each other. I think it’s kind of entertaining and it’ll be extra as they attempt to probably go into some of the tapers at some point, which I’m sure will touch a little deeper on.
Todd Davis: I think a couple of takeaways; one was the Fed has no clue why the 10 years 50 basis points lower than it was in April and they kind of went out and explicitly said that. To me, it’s interesting watching the Fed kind of in this position where they’re saying they will move, but it’s obvious, they don’t want to. They keep saying we’re willing to taper, we’re willing to move up but you can tell there’s just real reluctance to do it. And I think I keep going back to every timeline I see for the Fed, it all hinges around a smooth timeline and no bumps in the road. It’s a bit like Google Maps on a long trip; you’re going to get there in five hours. Well, I’ve got two kids, and there’s traffic, you’re going to hit bumps along the way and that seems to just push back and I think the Delta variant falls into that, kind of just a bump in the road that’s going to slow things down for the Fed.
Todd Patrick: You all think this is as much Delta. If you look at the pattern of Israel and the UK, which were about 50%, vaccinated, they’re closer to 60. Delta variant came to them about a month before we kind of started having it. So, the percentage of cases and growth, they’re here compared to population, we’re back anywhere from 100 to 200,000 cases a day. Significant move again, is this move over the fear of the market? Is this about this slowing the economy down? Or is it more about the acknowledgment that there may be more variants behind this? And how long this could be here? That’s the point I can’t get around.
Tom Fitzgerald: And I think, it’s probably almost inevitable, that we will see other variants. And it seems like the trend is at what, though, the last ones always worse than the one before.
Todd Davis: I think it’s more of a supply chain story. I think that as these variants emerge, and you see the supply chains, that we use smaller countries that don’t have vaccines, to find these variants, that just throw more sand in the gears, and create more bottlenecks and an economy full of bottlenecks. So, I think that’s the story as the next round of variants come up and that’s just, one thing that I keep coming back to is, the other takeaway from inflation is one of the cures for high prices is high prices. And I think that’s what’s driving things right now is you’re just seeing people throw their hands up and go, I’m not chasing this market, whether it’s lumber or materials or appliances. If these variants continue, and they continue to wreck supply chains, that could create the next slowdown, where people just postpone activity.
Todd Patrick: We kind of saw that in housing, this new home sale dropping the last time people kind of like, by now.
Tom Fitzgerald: Yes. And I think builders to kind of step back and said, I’m just going to build for margin and not build for quantity and so they’ve kind of cut back on what they’re building, I think to have, Powell, in the press conference, he focused again on the labor side of their dual mandate. And so I think he’s continuing with the transitory line inflation so he’s, while some of the Fed presidents may be a little bit more worried about inflation, I think he’s got that as a second category issue and the labor is the first category issue. And when you look, the initial claims numbers today that came out, they’re still over 12 million people getting some kind of unemployment benefit and it was like under 2 million before the pandemic. And so, I think he’s focused on that to get that number closer to where it was pre-pandemic and it maybe we never get back to that, given the labor participation changes.
Who knew that if you pay people to stay home, they would that would be shocking. That’s a good point it’s going to be interesting to see how that shifts when we get past September and all of that is all of those benefits expire so we’ll see. If all of a sudden the people that are saying they can’t get anybody to come to apply for a job but that kind of changes. Well, let’s before we get into recommendations on investments and kind of what you guys are seeing with your clients and what you’re, you know, all of that. Let’s just get a brief out, your view on rates, where are you thinking we’re kind of plumbing near the bottom of the range on the 10 years right now, where do you see us kind of going for the balance of the year and the balance of maybe in the next year.
Todd Davis: I’ll start; it feels like we’ve had a full rate cycle this year. We’ve just gone up and back down I will tell you that, we hit 175, in late March that felt overdone. We hit 112 last week, the week before that felt overdone. I think that we’re probably in a rage right now, somewhere 115 to 140; we probably just have some seasonal effects. I think we usually get a pullback kind of early fall there may be some opportunities there but I think the range is lower. The reason we didn’t hit 2%, earlier this year is that the tenure has become global security. And there just wasn’t a rosy enough picture of the global economy to justify that. I think that we’re at this lower range, because it’s a global security and I think when you look at global rates, whether it’s European trip, sovereign debt levels, we’re just going to be lower. So, I don’t think we have some big breakout higher, but we may drift up but probably somewhere in the 125 to 150 range is a good entry point along the way.
Todd Patrick: And along with the globalization, I mean, there’s still 16 trillion worth of negative rate global bonds out there. So, we’re sitting at one and a half to 175, we look cheap, and the money’s coming in and so you look at the dynamics of globalization, but also it’s kind of goes back to the taper with the Fed. Part of the reason we’re having that is just so much cash in the system, and people are looking for places to put it, that’s why stocks are all-time highs, that’s why Loma, partly because housing has gone up. And also, but it’s making bonds attractive to people looking to place money somewhere. And so I think the concept is here is that when the taper happens at some point, and then this cash is being drained from the system, which is not what the taper is, the taper is stopped putting less cash in the system.
If they stopped mortgage backs, again, abruptly tomorrow, they’re still spending 80 billion a month in treasuries, which is more cash in the system. So, think about how long it takes for them to fully taper and then you hit the phase of we’ll just reinvest the current portfolio, then you get the quantitative tightening, we’re ways away from cash being drained in with the desire that cash having to be placed somewhere. And with stocks at elevated levels, an all-time high for most valuation perspectives, and now, other assets, commercial real estate is still getting traded at four caps just historically expensive stuff. I think bonds will continue to look attractive as a place of safety, it’s the one asset, we can get out of pretty quickly. And so it feels like we should be higher but there are a lot of hurdles to make that happen.
Tom Fitzgerald: And I think too, we got the GDP numbers for the second quarter, right before we came on the air here. And so it was a little bit disappointing, there was six and a half percent, I think they were looking for about eight and a half but when you kind of dig into the numbers, a lot of that shortage came from inventory not being there. And so there was a drawdown of inventories and again, that kind of speaks to your supply chain issues that are going on, not in just the housing market, but other industries as well, where they just can’t get pieces and parts for whatever they’re building. And so it kind of cuts back so that the inventories are being drawn down that’s kind of a negative for the GDP calculations.
Todd Patrick: Wasn’t all that kind of like just amazingly perfect storm, not only just the pandemic portion of it, the Suez Canal being blocked the world kind of all opening at the same time after being closeted for a year, from the freeze in Texas, stuff. It’s just the amount and the various flooding in Ohio for semiconductor parts; you list down a list of 10 items that you think probably would all rarely happen. They all happened inside about 15 months of each other.
Tom Fitzgerald: We had 10 Black Swans [inaudible 14:34].
Todd Patrick: It is almost mind-blowing how much is going on. So, you do lean back to the Fed to this being transformed by the number of just unusual factors, taking place in the same little time window. So, it will be interesting.
Tom Fitzgerald: And one thing I would say to go back to the rate discussion is that I think the market has kind of looked at the increase in the Delta cases and say okay, it’s going to stretch out the recovery in the second half, it’s going to be probably lower and slower than then maybe we thought it would be a month or two ago. And part of that was that people might still be hesitant to get out and do that face to face transactions but one interesting thing I saw on the GDP numbers was of that service, that kind of handoff from the good side of the economy to the services side looks like it’s happening that services and spending went up in the second quarter. Now, a lot of that, it was before the real pickup in cases. So what kind of, it’ll be interesting to see how that prevails into the third quarter, to see if we continue to see that again, that handoff from the good side to the services side. So, that’s one of the things I’ll be kind of keyed on and looking at in the third quarter, because that’s something I think the market is saying, now, it’s going to be a little bit, as I said, a little bit lower a little bit slower than what we were thinking a month or two ago.
Todd Davis: That’s an important thing that I think people need to keep in mind when they think about these inflationary prints and these numbers. And our economy is historically 70%, service-based and 30% goods based, we went through a period where there was no service sector, so you had an entire economy chasing 30% of the assets, or 30%, of the production of the economy. And that’s gonna create some inflationary pressures, that handoff should occur at some point and it’s starting to happen but that should help smooth things out also and…
Todd Patrick: Well, I’ve got like eight flights and like 10 days here and so if you’ve been to the airport at all, you see the service side going, it’s chaotic in all airports and trying to get a rental car. They sold half their fleets to survive, and then they have almost an overnight demand, low supply, high demand, you raise prices but again, and that’s going to filter its way through. And so I think, the Fed should hold her nose, I was looking at various ad articles a couple of months ago and I look we’ve had two higher periods of inflation here in the US, one post World War Two, the second being, the late 70s, early 80s, that were most looked towards.
And if you look at the Fed handled both of those two instances, extremely differently they rate kept and kept rates low during the post-World War Two, and in they were aggressive and raising rates, the 87 80s periods. Well, what was the key difference? Well, coming off the World War, we had a debt to GDP, well over 100% historical highs. Well, we had paid that down through a period of prosperity to about 30%, the late 70s. And so by raising rates, we weren’t incrementally just banging the fiscal government with increased cost but we just came out the wrong version of war and we’ve got debt GDP over 100% plus again. So, even if inflation does become a problem, the Fed is showing their past playbook, they were extremely limited and be able to raise rates, like we fear that happened in the 80s. So, it may happen, but the Fed may not be will do anything about it raising rates doesn’t increase the supply of goods so it’s going to be interesting to see.
Tom Fitzgerald: Well, so I think we can kind of summarize that we don’t see that that long term catalyst for either higher inflation or for higher rates in the given the fact that, we think the Delta variant is bad here, it’s a lot worse than some other parts of the world and as you said, Todd, we’re global security, whether we like it or not, I think in the long run that benefits us, and it’s going to keep an I think a lid or at least kind of keep the rate increases at a modest or moderate level going forward. So, let’s move on now kind of talk about what you guys are kind of interacting with your customers, as far as what’s working for you, Todd right now and kind of this year in, what are you having success with? And what are your customers telling you about their concerns and the issues they’re dealing with?
Todd Patrick: It seems to me cash is still flowing in the doors for most loan demand is still overall fairly weak for most. And so it’s that idea of how much do I sit here, but it seems like this recent rally has spooked bankers in general about a big pullback, it’s not only just that, hey, I was getting one and a half, 116 or 20-year mortgage paper, and now it’s 130. It’s like now I’m worried about extension risk and price fall, it has adjusted recently on that side. And so I think bankers are becoming increasingly afraid of its big right pullback, and so they’ve been a little more hesitant in placing money in the market right now but I’ve had a lot of success in getting people to look at I’m shifting the existing portfolio. I think that this rally has given us some good opportunities. I do some shifts in the portfolio, in particular on the thing that I think has been highly successful, is going back and looking through portfolios and looking for odd-lot mortgage-backed securities. They’re odd lots because they were bought long ago, which is most likely at a higher rate market and so there were gains in them.
And so you can clean up smaller positions in the portfolio, while they’re still big enough to get somewhat of a decent bid. And if you look at them, because they were bought at a higher market, the underlying whacks are elevated enough that the pre-pay should keep coming in at a fairly fast pace. And so it’s only going to pay down to a little odd kind of a nothing position pretty quickly. And so, we’ve been selling those, cleaning up the portfolio, looking at the game we can get, and then going back and going, hey, last year, we were overwhelmed with cash, look at how many bonds we bought at the 10 year Treasury sub 1% closer to 75 basis points. And so we’ve been lifting those bonds back up the curve, example, last week had a bank, we sold 26 odd lot positions that amounted to about $8 million.
So a bunch of cue subs for not that much money but close to $175,000 gain went back, and we’re able to pull out 25 million and bonds that they bought on the average Treasury about 72 basis points, and move those back up the curve. So, significant opportunity to clean up, reset, and then you can make that decision and then if you are worried about extension risk and duration exposure, the stuff that a lot of bankers bought last year was longer because we needed a yield and the curve was so flat, that’s a good time to kind of readjust to and maybe put back some more moderate duration things in the portfolio. But that’s been a good outlet in the last few weeks that I’ve seen that some bankers be able to take advantage of.
Todd Davis: You know, a lot of the same conversations, I mentioned earlier, it feels almost like we’ve seen a full rate cycle this year, where we’ve gone up and then back down, and kind of gone round trip. I think that has created a situation where, three months ago, banks, we’re looking at their bond portfolios with a few regrets, like, I can’t believe I bought that I can’t believe I moved out the curve, we’re back down here now and people are paying more attention to price risk. People are paying more attention saying, you know what, I don’t want to get caught offside, I want to be in something a little bit more conservative, willing to give up some of that income to stay well-positioned no matter what rates do.
What opportunities are we talking to people about? One is that you now have an opportunity to clean up some of those regrets some of the things that you looked at in early April and said I shouldn’t move that four out the curve. That thing extended further than I thought it would, we’re now back at a point where some of the market values on those are digestible, you can take that loss or almost breakeven on it. The other thing is that, the second half of this year and next year probably looks different in terms of banks, and their profitability. A lot of the one-time items, whether that’s, negative provisioning, PPP, the refile waves, probably start to slow down, and you’re left with your core margin, and that will drive the profitability of the bank.
Tom Fitzgerald: And the curve is flattening them again.
Todd Davis: Yes. And so what was a favorable trade and the steepness of the curve is kind of gone away from you. So, a lot of it is like, variations of what Todd was just mentioning, where you can move out the curve, or kind of reposition and pick up more income, that’s going to be a creative long term over the next 24 or 36 months.
Todd Patrick: So, okay, here’s the question. So how long does that last? That’s the mode that bankers are looking at now I’m okay, a little bit of regret, like looking back at your prom pictures, you’re like, and I’m wearing that. And so you’ve kind of, hit the pause button. So we do move back, we go back into shorter duration stuff, and if like, we’re saying there’s probably not that catalyst that allows rates to explode and now earnings get more difficult. At what point do they go again? Dang, maybe I do need some longer stuff back in the portfolio [inaudible 24:29] to see how it’s kind of the shift this full-rate cycle may come to a full investment cycle back in the psyche of investors.
Tom Fitzgerald: Because you’re still looking at I think pretty weak loan demand. I think the consumer has strengthened their balance sheet over the last year; with all the different stimulus checks that they’ve been receiving and so they’re not going out and getting loans in, they’re not getting the amount of either credit card lending that was going on, car loans, and etcetera. We kind of hear that over and over on the earnings calls from banks, as you know, the long growth has just not been what we were expecting it to be.
Todd Patrick: This is the only recession I’ve ever seen where average incomes went up.
Todd Davis: Yes, right.
Tom Fitzgerald: You know savings rates went way up. And so, I’m sure that they’re all kind of questioning that liquidity and how much of that is going to stick around for any length of time, but, maybe we get to the end of the year, and that loan demand still is kind of struggling. So then, as you said Todd, maybe we go back and revisit some of these decisions on the investments and say, okay, maybe I do need to try to squeeze more yield than I’m willing to go for it right now.
Todd Davis: Back to your point about liquidity, I read a piece the other day that talked about how we’ve gone through a global financial crisis, and now a pandemic, and in both of those people have left it saying, I wish I had more in savings. And you saw the savings rate kind of plateau higher after the financial crisis; it’s probably going to plateau higher after this one. After the pandemic, people are gonna keep more, you know, in savings. So, that’s back to our conversation about inflation that’s deflationary, not inflationary and that also means that your balances are probably more dependable than you think they are, as a bank.
Todd Patrick: They are. It is, that is the thing I think we’re all scared to death of, liquidity is a very linear direction and banking, right? Our banks are either overwhelmed with it, they’re all fighting over the same dollar, is it kind of goes in. But as the part for the taper, to me, that was saying, we’re afraid of that how much pullback but again, we’re a long way from the Fed ever getting starting to drain liquidity.
Tom Fitzgerald: When you see their balance sheet.
Todd Patrick: It’s shrinking and trying to pull some of the cash outs, I think the quiddity is going to be a different kind of problem for bankers, going for is that I still probably have too much.
Tom Fitzgerald: Too much instead of too little is unusual in the history of banking, at least for in our generation, too.
Todd Davis: And I heard it said, and it’s true. In the middle of the pandemic, we thought this was going to be a credit problem and the government has come in and said, banks, it’s not going to be a credit problem; it’s going to be a margin problem. And so you’ve got to make that shift and come in, is that.
Todd Patrick: Great call.
Tom Fitzgerald: Now, let’s drill down a little bit more, when we look at investment categories, mortgage banks lead the way on our bond accounting group, it’s about 60%, on average, the portfolios and so just wanted to get your guys thoughts on that mortgage bank market as a singular investment idea, and kind of where you’re trying to steer clients to in the different products, it started, like Todd said, we’ve been through a rate cycle, where from January to the end of March rates were going up, and it was like, okay, extension risk, maybe what we’re dealing with this year, and then from the second quarter, it’s been a reversal of that of those and so now we’re back into the prepayment protection ideas. So, kind of give us Todd Davis to let you kind of start and give ideas on what you’re seeing, particularly in the mortgage-backed sector.
Todd Davis: I think that you mentioned this briefly. Last year, it was a story of just waves of cash coming back to banks, and how do you get invested? And how do you kind of protection against that? I think we still have the guard against that, to me, it’s being a little bit more conservative on your mortgage-backed portfolio, focusing primarily on 15 years and 20-year polls. I’ve been looking at Cohort polls, whether it’s a low loan balance or a geographic profile, that’s New York, or Florida or Texas, historically, those two things, there’s evidence that the prepay slower in when you look back at what we did last year, with Cohort pools, the key thing is that there was some steadiness to the cash flow, it was dependable, and it was smooth.
And it was elevated, a little bit higher than a lot of what the models thought, but it was steady. And so dependable is good right now, as you look at 15, if you combine a mix of 15 and 20-year pools, with a five-year average life and a flat, a lot of the Cohort stuff doesn’t extend out, I’m looking at plus and down 100. That’s kind of crazy that you’re looking at those two, but you could we could go either way. And so if you can position yourself with something that’s got some protection, that doesn’t extend too far and doesn’t, shorten up and accelerated hat’s a good mix that kind of doesn’t let you get offside. It’s dependable cash flow, you can budget around you can loan back out as we see loan demand return, that’s what I’m focusing on the mortgage side.
Todd Patrick: Well, on that piece, I know you’ve had a lot of success with Cohort pools, and we’re paying a premium to get that preferential collateral. How are you figuring out where the premium gets too much?
Todd Davis: You just kind of have to evaluate it on a pool by pool basis. You kind of have to look at it, you can look at the historical speeds of that, and there’s good information on it. But that’s kind of what those two things are primarily the speed. You know, and then the download 100, you are paying more, but what you’re seeing is am I recouping that premium? Is that premium protecting the download 100? And that’s how I’m evaluating.
Todd Patrick: Yes, but I think is the issue and one thing you said is just started thinking about it, you great call on evaluating the bond or the up and down 100. But I think it’s funny, most bankers buy off the plus 300. What are the odds of us having a plus 300 is the tiniest 300 shock, but they look at the downside, but I think it’s kind of comical, in a way is that how many alcoves do you go in? In bankers say they hate the shocks because they’re not realistic, yet they buy bonds based on the extreme shock, kind of are you weighting that both sides of it.
Tom Fitzgerald: Because they’ve been beaten up by the regulators. My God I’m not going to go through that again. So, and to I know, you guys both have been big proponents of just still keeping it basic, as far as the product type, don’t go reaching for yield and esoteric or low liquidity type products, let’s keep it where we can, you’re going to buy investments that, maybe they’re not that you could get a better yield somewhere else. But this is an investment that if you needed to bid, we can get a bid in a matter of minutes.
Todd Patrick: Well, to get to find alpha, to give an above-market return, we’ve got to take some additional risk to achieve a higher performance bond portfolio, I get calls from makers all the time going such and such as my peer group, they’re yielding X percent, how are they doing that? I’m like, there’s no way you would buy anything close to what that bank buys another trailer park asset backbones me, and you just would not do that. So you got to find that risk component and that, to me is much more advantageous short and long term for banks for the risk to take would be duration risk, versus structure risk versus obscurity. Those don’t pay when you need it, the bond portfolios role is to be there and to elevate and minimize the bad when the economy takes in that stuff. Duration risk is the risk that offers that structured risk, yes, it might go up some value, but not to the degree that it should duration risk does. That’s why predominantly we been more pastors than CMOS not that all CMOS are bad sold one yesterday.
I think the value there is in the upfront portion of that of stability, that there’s overpriced in the past three markets right now, you can find some reasonable CMOS there. But if you’re looking belly of the curve out, to me, it’s not very often that the CMO is a lot better long term value, when you start factoring the structure of risk that it could change Trontz characteristics, the fact that the bid-ask is so much wider, and the availability of several bidders on that thus hits a lower bid, you’re kind of squeezed. So, in that, I think that duration piece and you don’t have to be complex to be good but you do have to take a risk and so for me that risk is to ration. And so where does the ration end up biting me, right?
That’s in that upright scenario, what most banks be in very asset sensitive, they should be sitting and going bring it on. I’ll allow 70 plus percent of my balance sheet to outperform and 10% to do poorly any day of the week. But most bankers are fearful of the rising and I think it’s still predominantly coming from they get a bond [inaudible 34:14] report every month that shows, quote, unquote, mistakes. Yes, [inaudible 34:18]. It’s about educating the board having a philosophy making sure they understand and when the leaders of the regulars come in, you use some of the tools they’re giving you like the economic value of equity, that supports your ability to have a longer duration, but you have a philosophy and you, I guess, allow them to see that you understand the risk that you’re taking and why that’s the proper risky for you to take, even if a sounder, more stable, more profitable institution.
Todd Davis: I think your points are good when that oftentimes in Alcoa meetings, you talk through the report and you say, well, we think rates are going up, and that’s the most likely and that’s what our rate forecast shows is we think rates are going up and we’re more profit in that rate environment. And then they in that part of the meeting, they say, okay, now we’re gonna talk about the portfolio and they say, well, okay, we think rates are going up. So we’re going to position our portfolio for that that’s just the wrong approach. You need to say, alright, what if we’re wrong? What if 80% of our balance sheet doesn’t do what we think it’s going to do? How do we position our portfolio to add some insulation, and to your point duration does that?
Todd Patrick: It needs to be contrary and part of the balance sheet. It’s like people who say you should have at least 10% of your wealth in gold or Bitcoin or something alternative asset, that in theory, that’s where the Bitcoin a bank balance sheet, the bond side, is the fact that where the when things go sideways, it’s the part that you know is going up, but it only goes up to the degree that which it should, is if you buy the right kind of bonds, and people chasing structure risk, and credit risk, I’m not including meaning because I don’t view that as credit risk, which we can get in that if you want but those outside of that those rare places that benefit the bank long term.
Tom Fitzgerald: Let’s talk you’d mentioned about being asset sensitive, and with all the liquidity on banks, with the low or no yielding deposits they have, I think you’re probably in your pertain to you use AL in your process quite a bit and so are you seeing like the deposit betas coming down on the modeling is as far as how they are looking at their assets, liabilities activity?
Todd Patrick: I haven’t seen it directly banks, purposely lowering their betas yet to acknowledge what we know, the reason that betas typically go up as rates rise is that linear nature of liquidity, and then we’re all looking forward because we got loan demand like crazy. And so we’re all fighting over the same dollars so we can be the one that gets to fund the loan. With the Fed having hit zero on the yield curve when they’ve lost that ability to drop rates lower slaves turn to flood us with cash as their simulative measure. And so now that you’ve you saw it in the Great Recession, and I think Chad [inaudible 37:11] did a great job of putting that together along with Billy of looking at how differential, the betas work as rates rise, post-Great Recession compared to prior, it was about half, there were about 45 basis points in the being close to the 22.
So, even the banks that have any address that they are a lot more asset sensitive than they realize, a based on the new monetary tool that the Fed has been forced to use them on that and bankers need to realize as well, that asset sensitivity is opportunity cost. We only look at it as a net positive thing, that if rates go up, look how much protection I have, look how much we’re going to make. Will you only get that if you’re willing to make less the day? Because everything that makes you asset sensitive, whether it is in a floating loan versus a fixed a shorter bond versus a longer, a longer deposit versus shorter deposits. All Costs are the day money. So asset sensitive, I get why you’d want to be there but there are degrees where you’re, I think you’re losing the opportunity to be profitable and what’s going to be like this Todd focused on a tighter margin window.
Todd Davis: When I think about betas, I look back to the last round of rate hikes and your beta on the first three hikes looked completely different than it did on the last three hikes. It was almost zero, we saw the Fed raised rates, and banks didn’t move their rates. So, understand that we’re in an environment where I think the Fed is going to be slow to raise rates, it’ll probably be one of the last things they do so that creates some time for you. And then you probably don’t get pressure on your deposit cost until we’re three to four hikes into that rate hiking campaign. So, that’s a pretty long runway, where you’ve got a good cost of funds a good cost basis that allows you to take some duration risk and feel good about it. Meanwhile, that bond that you’ve bought, rolls down the curve and kind of becomes a friendlier range by the time you see that pressure.
Tom Fitzgerald: Let’s finish up and talk about the other major sector most of our bank portfolios and that is the Muni sector and now that it’s been rich and it’s only getting richer as far as prices go. Just give me kind of your experience and what you’re hearing from your clients and what’s working are we continuing to sell them Muni’s or is it more of kind of swapping kind of moving up in credit quality what kind of is working for you guys?
Todd Patrick: Start with the former Muni’s.
Todd Davis: Yes. Insert joke there. We’re still seeing good demand from Muni’s, when you talk about adding duration to your portfolio, it’s, it’s still a good way to do it. The Muni market it’s also at an inflection point, there’s a lot of legislative question marks. As somebody who traded that market, it is a supply and demand market, more so than anything else. Levels, ratios, spread; it’s all determined by supply and demand, where we’re on the cusp of maybe having an infrastructure deal. There was a fact sheet released yesterday; there are a lot of questions about what does that looks like?
Does that look like a baps program where all of a sudden there’s more taxable issuance than there is tax-exempt issuance? So, what does that do to spreads? There was a fact sheet released yesterday on Wednesday. There’s no mention of a taxable program as part of that infrastructure program. So, that’s probably supportive of levels, the other question is, right now you can advance refund, a municipal deal with a tax-exempt deal, he can’t refund the tax-exempt with a tax-exempt. Rates have moved so low municipalities can refund tax-exempt deals with taxable bonds and save money. If there’s a change to that rule, and banks can now refund again with tax-exempt, that’s real uncertainty about what supply looks like in that market.
Todd Patrick: That was a real head-scratcher rule change, make sense. And it’s our RS policies around municipalities bill to fund themselves as cheaply as possible in a relaxed tax delay took that away.
Tom Fitzgerald: Never heard a good rational explanation for that.
Todd Davis: There was supposedly one piece published that kind of rail on it, but to your point, it doesn’t seem to make a lot of sense that if these municipalities are saving money to take that away from them, but that’s another podcast, probably. So that’s kind of what we’re looking at is, what do we do here, I still like taxable meaning slightly better. You can bind that 10 to 12-year range in getting 160 to 180, almost 2% yields almost in 15 years. I like that range because that 12-year bond is going to turn into a 10-year bond, and it’s going to turn into an eight-year bond and roll down the curve and it’s still a pretty steep curve in that market. The front end of the Muni market is been steady; I’ve been blown away at how steady the front end of that curve has been. So, it’s getting good support from the retail world, it’ll probably get continued support from the retail world. So, you can buy something in 1012 years, it’ll turn into a seven-year bond, eventually and there are some friendly evaluations in terms of pricing so, that’s my two cents on it.
Todd Patrick: I agree. And something I think that the bankers should think about as far as strategy, especially since all this liquidity, is that they’re scared of how much they’re putting out and growing the bond portfolio, yet they need income. But as our mind, if you’re willing to go out further out the curve, 10 million out 10 or 12 years may have the same impact as putting twice the amount out in three to four years that you feel it is safe. Well, if I keep half of it in cash and half of it out the curve, I’m sitting in a better position of probably just being a three or four or five-year window. The further you go in duration also limits the amount that you need to hit your earnings target and so it creates some flexibility on holding cash as well.
But as I say the legislative piece is big, I know we touched on a couple of weeks ago, the idea that the Biden tax changes come how it could influence the general Muni market, and the bigger institutions have lost their incentive to hold them because that could cause a tradeoff, now sell-off there. And so I agree, taxable space seems to be the cheaper of all, BBQ, historically; we’re looking at 100% of nominal treasuries as being good value. I think we’ve been in the 60s. It’s historically expensive and to think about it, I think you were dead on and calling the medium market being a supply-demand that no markets what’s changing either. There’s nothing maybe some supply through an infrastructure bill but now that it’s been a lot more limited in its potential scope.
There’s not a massive amount if also on the other side, you’ve got looking at the credited municipalities. They came out clean all the government supported me most of easily through all the rage report they had a good year and they’re waiting on federal funding to pad reserves for [cross-talking 45:02]. So they need to issue a lot coming up doesn’t seem that great so there’s not a boost of supply, they’re coming from it. And demand is not going away anytime soon A, again, with fed pumping cash into the system, the economy now actually growing I mean, we could play about six and a half percent every time so we do that but there’s still a lot of the need for tax shelters. So, there’s nothing to me this is going to change the Muni markets richness or potential value in this curve right now.
Tom Fitzgerald: And as you said, tax rates are probably only going to go up from here so that’s another bonus for the like it. So anyway, guys, we’ve given our listeners a ton of stuff to chew on and I want to just thank you guys for your time, your insights we got to do this more often.
Todd Davis: Does this mean we’re like regular callers on a [inaudible 45:51] talk show now?
Todd Patrick: That’s about the peak of our ability to be on the radio or some early [cross-talking 45:56].
Todd Davis: [Inaudible 45:58] Southwest Atlanta.
Tom Fitzgerald: Alright guys. Well, thanks a lot and thanks for coming.
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