Interest Rates on the Rise

Have you ever had the sinking feeling when you missed a plane, bus, or a train?  I remember that well when I was in elementary school and I messed around getting ready one morning.  The bus stopped at the end of my driveway and I walked by our living room window just in time to see it pass by.  I hurried to get my books and sprinted out of the house and up the street toward the speeding bus.  I just had one problem, my top speed could not match the rate that the bus was travelling. 

Finally, I wised up and lurched down the hill to our house.  My mom had to take me into school that day and I had to pay the punishment for the next two weeks for dilly-dallying around instead of being on time. 

I am sure that everyone has experienced missing a bus, connecting flight, or carpool ride.  The feeling in the pit of your stomach is awful.  We have something occurring right now that can do more damage to your profitability than re-booking the flight; the low interest rate train is leaving the station!

This is a classic where the borrowers are scrambling to get deals with interest rates like they did 6-12 months ago.  It is also the time when some lenders who are not looking at the world around them, will be silly enough to grant the terms that the borrower wants.  The result is maddening enough to make the CFO and Asset-Liability Committee comatose.

Last week, we received in two new participation projects.  Both are asking for 10-year rates at 4.25%.  Both should have had their projects ready to be funded last June if they wanted to be in this ballpark.  The sad thing is, there is probably some banker out there who will give this to them.

We have seen the 5-year U.S. Treasury increase from 1.73% late in August 2017 to 2.57% at the end of last week.  The 10-year U.S. Treasury was close to 2.00% at the same time and has jumped to 2.857% on Friday.  Each of these is an 80+ basis points increase in the interest rate compared to a mere 5 months ago. 

It also looks like interest rate increases may continue.  The Federal Reserve has indicated they may increase the Fed Funds rate three times this year (March, June, and December).  This would put the shortest-term rate at 2.25% heading into 2019.  The Fed is concerned with very low unemployment and rising wage growth that will light the fuse for inflation.  The Fed counteracts inflation with rising the level of interest rates to cool off the economy.

Economic growth is also strong and leads to possible higher interest rates.  The Federal Reserve Bank in Atlanta, forecasted GDP growth at 5.4% for the first quarter of 2018.  We will see if we hit this, but this is a level that we have not seen in a decade.  People are feeling better about themselves with additional money in their pocket from the Trump tax cut and extra bonus money from corporations who are sharing their tax savings with their teams. 

Consumer spending is up.  Business investment is increasing.  The optimism index of the NFIB is increasing from an all-time average high in 2017.  All economic indicators are pointing to a great year.  Couple this growth with upward pressure from the Fed and increased demand for credit if we run high deficits and you have the recipe for rates to be a full percentage above where they are today, at this time next year. 

At this point in the cycle, it is important to realize where we are and take appropriate action.  First, realize that you will have to pass on some deals if the borrower continues to be stuck in last summer’s interest rates.  Learn to price loans where the market is today and considering the direction in the future. 

Next, increase your hurdle rate you use to underwrite deals.  We underwrite to a higher interest rate to see how the deal will “act” when rates are at higher levels than they are today.  Last year our rate was at 6% to test deals at.  We are moving it to 6.5-7% for underwriting purposes.  Also, look at lower rate credits that are coming up for a reprice.  How will that impact the business performance?

Finally, pay close attention to areas in your portfolio that are in trouble.  Higher rates will not make the borrower any more successful than he was with the lower rates.  It will make things worse.  Watch out for your problem loans that are not performing now, regional areas that are struggling, or sectors of the economy, like agriculture, that are unable to generate high enough prices to keep their margins strong. 

So, the interest rate train has left the platform.  Are you on board with the current market conditions, or are you still chasing the caboose as you run behind the train?