At the top and bottom of every business cycle, interest rate transitions are inevitable.  Interest rates fall in a weak, deflationary economic environment, and rise in a strong, inflationary economic environment.  In debt-laden economies, the speed of the transition is what is important, not the absolute rate.  Especially with rising interest rates.  When interest rates rise too fast, things tend to break.  So how fast is too fast? 

In the chart below, I have taken the change in yield on the 10-year Treasury bond over a one year period.  I then measure that change against the long-term average rate of that 10-year Treasury bond.  As you can see, there is definitely a point where either credit problems develop, or where asset prices (fueled by debt growth) hit a ceiling and reverse direction.  If you review history, you will see that all of these peaks (red peaks) correspond very well with past crises.  



What is also obvious is that today, the 10-year Treasury bond has risen too fast, at least according to history.  Does this mean that a crisis or market crash is about to happen?  Not necessarily.  But what it does mean is that you can expect more interference with bond yields from the Fed and, sooner rather than later.  We will talk more about this at the April 9th ALMEdge webinar.  

Great news, sort of.  According to my very broad master economic model, the recession has ended as of September.  This would make it the shortest, deepest recession in modern times.  Of course, we won't know the official end date until NBER actually comes out with their official announcement.



This is no doubt good news, but, as is always the case with economic forecasts, there is one big caveat.  The next chart separates the model data into monetary components (think stimulus) and economic components (think real activity).  It clearly shows that significant parts of the US economy have not reached a self-sustaining mode yet.  The economy is still very dependent on stimulus from both the Fed and Washington.  If either of these source dry up, it is likely the economy will slide right back into recession.  Gee, isn't that comforting, reliance on the Fed and Washington, funny stuff.


 

Clearly, the US economy is doing better today than it was just one quarter ago.  People have returned to work and sectors like housing and rail traffic are actually booming.  This is great news, however, for community bankers, this remains an incredibly challenging environment.  With the Fed growing its balance sheet and the government giving out a large stimulus package, banks are flooded with excess liquidity.  Worse yet, its liquidity with no maturity date. 
                            
      

Another great challenge we are/will continue to face is the fragile condition of small businesses.  Equity indexes have recovered all the losses suffered during the initial impact of shutting down the US economy, however, it is only a few, very large companies driving the indexes higher.  Small business earnings remain in a steep bear market.  As you can see in the following chart, small business earnings are in critical condition.
 
        

This presents a big challenge to banks because it is difficult to underwrite companies that have no earnings.  Second, and most importantly, as the next chart shows, the number of “zombie” companies, defined as companies where profits are less than debt expense for the last 3 years, are near an all-time high.  It would appear that trouble in the credit cycle is just beginning.
 
     

From a risk management perspective, our risks seem well defined for us.  Rates are incredibly low (we can’t change this), margins are under pressure (we can change this) and credit conditions are difficult (we can still find good loans to make).  These are difficult times no doubt, but with a plan and the will to execute the plan, this too, shall pass.  Next year looks much better than this year.  There are some very promising vaccine candidates on the horizon which should allow the economy to really open up late next year.  If you need help developing ALCO strategies Luke and I are here to help.  If you need help putting excess liquidity to work, please call your UBB Securities representative, they have products that will help limit some of the margin pressure you face.