As a lender, you are often asked about interest rates and the level of rates in the future. I always would joke and tell a junior lender if he wanted to be right with 100% certainty about where interest rates will be, just answer the borrower that “rates will fluctuate.”
Sometimes, rate swings come as a complete surprise, like the announcement in early October 1979 made by then Federal Reserve Chair Paul Volcker. Volcker in a rare Saturday news conference, said the Fed would switch to managing bank reserves instead of managing the Fed Funds Rate, which he admitted, will result in greater fluctuations in rates. Boy did it! By late 1980 the overnight Fed Funds Rate hit 20%. Volcker’s goal was to wring runaway inflation out of the economy. The actions did stop inflation, but it also threw the country to a recession and drove up interest rates to levels where many farmers and businesses were forced to close.
We have the luxury today of not being blindsided by what we expect to occur. The Fed pumped large amounts of liquidity into the banking system after the 2008 crash. The economy has grown since then, albeit at a much slower rate than we have experienced in many other expansions. Inflation has remained in check within a range set by the Fed. Commodity prices have dropped from highs we saw five years ago. Unemployment is low and we are starting to see improvements in the labor force participation rate.
So, with all this good news of slow growth while having a lack of inflation, usually the Fed will move toward a policy of allowing the economy to grow if their concerns about price stability is minimal. But now we have a Fed who remembers that pre-crash they had around $780 billion of US debt on their balance sheet. Today that level is at nearly $2.5 trillion. The record level of US debt on the Fed’s balance sheet hinders them from purchasing more bonds to inject cash into the economy when that may be needed to stop a downturn. Couple this with already low interest rates, that have stayed low for a long period of time, and if an interest rate drop is needed to stimulate the economy, there is no level to drop the rate from to create new excitement.
We are left with a Fed who does not have the reason to increase rates to keep prices stable, but who finds it must do so anyway. For months, the Fed has looked for any new sign of significant inflation with none to be found. The economy of the world is quite a bit weaker than we saw 3-4 years ago. Even though there are none, Fed Chairwoman Janet Yellen, has stated in several comments that the Fed sees no reason to back off their plan to increase the Fed Funds Rate and begin selling its US Government debt portfolio at a measured pace.
Such actions will increase both the short-term end of the yield curve, with Federal Funds Rates, and the long term, with the sale of bonds. That strategy from the Fed is creating their desired results. We have seen secondary farm lending rates rise around 50 bps on the three-month end of the scale to around 70 bps on the 30-year end in the year ending late August 2017. This appears to be the trend going into the near future as more rate hikes and bond sales are on the horizon.
What does that mean for a lender? First, now is the time for producers who can, to lock into long term, secondary market fixed rates on their land, and eliminate the interest rate risk if rates increase in the future. This will often help the farmer better manage his cash flow. We have several products that can help move the land loan off your institution’s balance sheet. Now many CUs may not want to offer such a product, but doing so is a way to save the relationship. If you do not offer it and entity like FCS will, and they will take the entire relationship away on your good producers. Contact us at Pactola for help!
Next, watch your pricing strategy. Remember you have an environment where borrowers have been expecting and getting very low interest rates. They will push you for the same rate they may have nabbed on the last deal they closed a year ago. But to keep the same margin from last year, that rate will have to be another 50-70 bps higher today. This may mean that you lose some deals to the lender down the street who is not as astute as you are. Use prudence, and allow the weaker ones to go if need be. By the time reality sits in, that lender will have marginal credits priced at low levels which will impact his margin negatively.
If possible, show the client how you will price their loan and leave it open during underwriting to be locked a week or so before closing. That is the method we prefer since it preserves the margin of the loan for the lender if interest rates have moved higher during the analysis time.
The easiest time to be a lender is when interest rates are steady. The most profitable time could be when your cost of funds is dropping and the overall lending market has not caught up with those decreases. Margins can grow quite fat in those times. The most challenging is the one we are in, where interest rates are increasing and oftentimes many of your competitors are blind that their cost of doing business has been climbing.