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Interest rate forecasts in today’s market: Planning your ALM position

Dave Koch
February 1, 2023
Read Time: 0 min

Where rates are headed

As regulators focus on interest rate forecasts used for interest rate risk management, remember that flattening, steepening, or inverting yield curves can influence your projections.


You might also like this on-demand webinar, "Deposit strategies for funding challenges"


Rising-rate environment

Planning ALM strategies

After decades of accommodative monetary policy and near 0% interest rates, financial institutions find themselves in 2023 with a question on where rates are headed and how to structure their strategies given rate movements. “How many twists, turns, loops, and drops does this rollercoaster have, and how do I plan my ALM position?” they may wonder.

Many experts predict that the Fed is nearing the end of the rate hikes they started to rein in inflation. However, the Fed has been signaling that they are not yet done and that their expectations for long-term interest rates are at a higher level than many people expect.

A fed funds rate that stays in the 4.5-5.5% level as the “new normal” seems plausible. But what does a 5% fed funds rate signal for longer-term Treasury rates?  Presumably, that would pressure those rates to rise significantly to return to a more “normally shaped” yield curve. Whatever is in store, it is completely expected that the future of interest rate management requires a more realistic approach to potential outcomes.

Focus on earnings impact

Regulatory focus on rate forecasts

Since the Great Recession, regulators have been asking institutions to focus attention on the asset/liability management (ALM) process, specifically on potential interest rate movements with greater probability of occurrence than the traditional immediate and permanent (I & P) “shock” scenarios. In fact, the Office of the Comptroller of Currency has been requesting their institutions to track the potential impact on earnings from scenarios like a flattening, steepening, or inverting yield curve.

This change in approach introduces new variables in the interest rate projections that for decades have been a non-issue as we were effectively in a 0% interest rate market. But with the recent Federal Reserve actions, it becomes essential to understand the meaning of these forecasts and how a simple name can be viewed differently depending on where the market is heading.

Markets move in unpredictable ways when least expected. Since interest rates are an ALM input that we must respond to, it is crucial that we consider variations in them that are both realistic yet pushing beyond comfortable levels to ensure we assess the potential risks. The absolute rate levels are less important than the overall changes in both levels in rates, as well as shapes in the curve. 

To better understand, let’s begin with a basic definition of the mathematical relationships in each of these projections.

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Flattening, steepening, inverting

Yield curve scenarios

Flattening yield curve.

A flattening curve is when short-term market rates move up or down at a faster rate than the longer-term rates. Flattening curves can take place because rates are increasing or decreasing. This difference defines a “bear” or a “bull” market event.

·       Bear flattening: A bear flattening of the yield curve occurs when short-dated yields (e.g., 2 yrs) rise more than longer-dated (e.g., 10 yrs). This is a typical environment when the Federal Reserve is tightening monetary policy and raising short-term rates.

·       Bull flattening: A bull flattening of the yield curve occurs when longer-dated yields fall more than short-dated yields. This happens when market expectations are for a reduction in inflation or a flight to safety.

Steepening yield curve

A steepening curve is when the long-term rates are higher than short-term rates. This is also known as a positively sloped yield curve. Like the flattening curve, the steepening curve can be a “bear” or a “bull” event for the market. How the slope happens defines whether the market is considered to be in a “bear” or a “bull” market event. The typical measure of the steepness is the spread between 2-Year and 10-Year Treasury rates.

·       Bear steepener: A bear steepening curve is driven by changes in long-term rates. Long-term rates are rising faster than short-term rates. Bear steepeners occur when markets expect inflation to rise and thus the Fed is needing to increase interest rates.

·       Bull steepener: A bull steepening curve is driven by falling short-term rates, which has a greater impact on the yield curve. In this case, interest rates fall on short-term rates faster than long-term rates, indicating that the Federal Reserve is cutting short-term interest rates. This movement is a sign of expected economic growth and a belief that the Fed is going to reduce interest rates.

Inverting yield curve

An inverting yield curve is defined as a curve where short-term interest rates are higher than long-term rates. Investors are not receiving financial compensation for the risk of time in their investments. This can also be referred to as a negative yield curve.

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Inverted curves reflect a market where investors expect long-term interest rates to fall. Historically, when yield curves invert, recession follows shortly thereafter.

Applying to today

Adjusting to rates and conditions over time

Looking back to the market rate movements over the past two years we can see in the figure below how different movements combine over time to arrive at the current market conditions.

Using yield curve rates in interest rate forecasting

Source: U.S. Department of Treasury

Looking back to the June 2021 rates, we see a positively sloped yield curve, where the spread between the 10 Year vs. 2 Year Treasury stood at 1.4%. As market rates began rising in March of 2022, we experienced a “bear steepener” environment (green line) where there was a sharp rise in long-term rates vs. short-term rates. Moving from March to September or December of 2022, the short-term rates moved much faster than long-term rates – a “bear flattener” movement (gray, rust, or blue lines). However, that movement went too far, resulting in an inverted curve.

Understanding interest rate forecasts with yield curve spreads

Source: U.S. Department of Treasury

Using the 10 Year-2 Year spread as a gauge, the yield curve inverted in October 2022. During that time the 2 Year Treasury rates were still rising significantly faster than other rates. If we compare the 10 Year – 3 month spread as a gauge, then the inversion began back at the end of Q1 of 2022.

What does this all mean? Well, each of these interest rate types combines with time to create a new set of market conditions.

Variable and unpredictable inputs for market rates

Given where we are now in the cycle, it is plausible to assume a continuation of an inverted curve. The Fed has signaled more rate increases, and the bond markets seem to be retreating in yield, so we would expect another year of inversion. Then in the following year, the Fed may begin to relax rates, and we could see a mild “bull steepener,” but that may not result in a positively sloped curve, but rather a flatter curve in that time horizon.

It is also possible that the Fed will raise short-term rates and long-term rates respond upward as well.

While we attempt to measure the impact of changing market rates on earnings and capital as part of the ALM process, we must recall that these inputs for market rates are variable and unpredictable. Measurements that assume absolute levels or fail to make adjustments to rates and conditions over time will likely misstate the level of risk in overall earnings and equity levels.

It is important to understand how the interest rate cycles are being presented in your ALCO package and how those movements would impact strategies such as deposit pricing and retention, loan structures and rates, etc.

For example, consider if you run a rate scenario where all rates move up by the same amount over the same time frame in an unlikely event. The spreads between short- and long-term rates are likely to compress or expand, making the decisions on investment or funding durations and pricing very different. That is not to say we won’t see rates move for some time where the spreads are fairly constant. But the longer-term realities are not to see extended periods of inverted yield curves as an example. We recommend running the analysis on a short-term basis with continued inversion vs. a return to a flat or positive slope to understand how the shape of the curve impacts overall earnings levels. This is called yield curve risk and is one of the five key risks to identify in the ALCO reporting process.

ALM can be run in a simplistic way or it can be made more complex with better management of key issues like the interest rate forecasts. If you are attempting to quantify risk levels and overall earnings better, then working at understanding and testing these more complicated ideas is a way to improve overall performance. 

For insight and assistance on ALM modeling and inputs, consider using ALM advisors.

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About the Author

Dave Koch

Director, Advisory Services
Since 1989, Dave has delivered educational programs on Asset/Liability Management and pricing topics to Federal Regulatory Agencies, national and state industry trade groups, Federal Home Loan Banks, and Corporate Credit Unions nationwide.

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