​Funding Amidst Rate Cut Uncertainty

July 30, 2024, marked one full year since the last change in the Federal Funds Target Range when the Fed elected to raise the range by 25 basis points to 5.25-5.50%. However, just because short-term administered rates have not changed for a while, uncertainty about the timing, direction and magnitude of the next move has not been muted.

The chart below shows the three-month Classic Advance rate and the implied three-month Classic Advance rate nine months forward, as derived from the rates on Classic Advances at longer tenors like six months, nine months, and 12 months. As market sentiment has shifted between the prospects of rates remaining higher for longer and a sharp pivot, the yield curve has reflected those changing expectations. During parts of the first quarter of 2024 and again in the third quarter, the forward-looking three-month rate was lower than the current three-month rate by more than 100 basis points.

Members who extended maturities on funding during previous periods of heightened dovishness have been rewarded with interest expense savings. For example, using the 12-month Classic Advance at rates in the mid- to high-4% range in January 2024 yielded favorable results compared to a strategy of rolling shorter-term advances in the mid-5% range. However, without the benefit of hindsight, the appropriate strategy going forward is less clear. Rate cuts may materialize at the expected pace, or under- or over-shoot expectations. But it is clear that volatility and uncertainty remain at elevated levels.

One way that members can capitalize on higher volatility is by utilizing the SOFR Flipper Advance. The SOFR Flipper Advance is very similar to the HLB-Option Advance allowing members to borrow at rates below Classic Advances by selling the option to FHLBank Boston to cancel prior to final maturity. The key difference is that the SOFR Flipper is a floating-to-fixed advance, whereas the HLB-Option Advance carries a fixed rate. 

An important feature of the SOFR Flipper is that members can select the amount of discount applied to SOFR for the floating-rate period in addition to being able to tailor the maturity, the lockout period, and the put frequency. For example, the below table highlights two different structures with a varying amount of discount (-100 and -200 basis points). Accordingly, the back-end fixed-rate coupon is higher when the SOFR Flipper has a bigger discount on the front end.

With uncertainty as to the timing and magnitude of potential rate cuts, the SOFR Flipper creates a margin of cushion where capturing interest expense relief can be achieved in various interest-rate scenarios. 

As the scenario analysis below highlights, if 25-basis-point rate cuts were to commence in September and continue through August 2025 resulting in a total of 200 basis points of cuts, the initial discount and floating-rate feature of the SOFR Flipper Advance would produce a lower all-in funding cost than the fixed-rate HLB-Option Advance. And with the post-lockout fixed rate of the SOFR Flipper Advance at similar or slightly higher levels compared to the HLB-Option Advance, the extension and contraction risks would be comparable. A strategy of rolling short-term advances like the SOFR Flipper, would also see the total funding cost decrease as market rates fell, but it would be starting from and ending at the mid-5% to mid-4% range, which are at higher nominal levels than the SOFR Flipper and HLB-Option Advances.

Alternatively, the benefits of the funding cost savings with the SOFR Flipper are likely to be that much more impactful if a softer landing for the economy materializes, with interest rate cuts occurring at a slower pace and to a lesser degree than is currently expected. This is especially true for structures with deeper initial discounts. In a scenario where rate cuts start in September 2024 but proceed at an every-other-meeting interval for a total of 100 basis points of cuts by July 2024, there are still considerable savings compared to the rolling-short strategy. And the -200 basis points SOFR Flipper outpaces the HLB-Option Advance again as well. With 100 basis points of rate cuts, which would imply SOFR being around 4.30% in August 2025, the likelihood of extension risk for the SOFR Flippers, with back-end fixed coupons in the high 3% or low 4% range, would be reduced compared to the 200-basis points of cuts scenario.

Recent market conditions have created challenges and opportunities for FHLBank Boston members. Our Financial Strategies group has developed a suite of analytical tools designed to help you identify the funding solutions that best fit the unique needs of your balance sheet. Please contact me at 617-292-9644 or andrew.paolillo@fhlbboston.com or reach out to your relationship manager for more details.

FHLBank Boston does not act as a financial advisor, and members should independently evaluate the suitability and risks of all advances.  The content of this article is provided free of charge and is intended for general informational purposes only. FHLBank Boston does not guarantee the accuracy of third-party information displayed in this article, the views expressed herein do not necessarily represent the view of FHLBank Boston or its management, and members should independently evaluate the suitability and risks of all advances. Forward-looking statements: This article uses forward-looking statements within the meaning of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995 and is based on our expectations as of the date hereof. All statements, other than statements of historical fact, are "forward-looking statements," including any statements of the plans, strategies, and objectives for future operations; any statement of belief; and any statements of assumptions underlying any of the foregoing.. The words "expects", "may", “likely”, "could", "to be", "will," and similar statements and their negative forms may be used in this article to identify some, but not all, of such forward-looking statements. The Bank cautions that, by their nature, forward-looking statements involve risks and uncertainties, including, but not limited to, the uncertainty relating to the timing and extent of FOMC market actions and communications; economic conditions (including effects on, among other things, interest rates and yield curves); and changes in demand and pricing for advances or consolidated obligations of the Bank or the Federal Home Loan Bank system. The Bank reserves the right to change its plans for any programs for any reason, including but not limited to legislative or regulatorychanges, changes in membership, or changes at the discretion of the board of directors. Accordingly, the Bank cautions that actual results could differ materially from those expressed or implied in these forward-looking statements, and you are cautioned not to place undue reliance on such statements. The Bank does not undertake to update any forward-looking statement herein or that may be made from time to time on behalf of the Bank.