The Fed raised rates for the 2nd time in 2018 taking the target Federal Funds Rate to 1.75% – 2%. Chairman Powell updated the committee’s rate hike forecast to 4 hikes in 2018 and noted that “the economy is doing very well”. US CPI rose to 2.8%, the highest reading since Feb 2012 and well above the Fed’s 2% inflation target. We will look at the Fed decision and inflation in the economy in detail below.

In FinTech financing news, Braviant Holdings, a fintech non-prime lender, has secured a $50 Mn debt facility from KeyStone National Group to expand lending. European fintech payment processors WireCard and Adyen had successful IPOs with stock prices rising significantly after going public. Both these companies provide payment processing for online transactions. WireCard has a partnership with Visa and Adyen is eBay’s sole payment processor.

Lending Club priced its $299 Mn CLUB 2018-P1 deal this week at tighter spreads but higher yields as compared to those on the CLUB 2017-P2 securitization. Spreads on the A, B and C tranches were 5 bps, 35 bps and 40 bps tighter respectively. Yields were 75 bps, 52 bps and 45 bps higher respectively. Rising rates have impacted lenders funding costs and spreads are not tightening enough to offset the impact of rising interest rates.

CLUB 2018-P1 has 50 bps more overcollateralization than CLUB 2017-P2 and 38 bps lower excess spread. Credit enhancement on the A tranche has been steadily coming down and the A tranche on CLUB 2018-P2 has 123 bps lower credit enhancement than that on the prior deal.

PeerIQ Webinar

PeerIQ hosted a webinar by CEO Ram Ahluwalia on “Lending Earnings Insights 2Q2018” on Wednesday, June 13th. Ram spoke about where we are in the credit cycle, the loss provision and credit performance trends of lenders, and the focus on technology by lenders. Reach out if you missed it or would like a copy of the presentation!

                                                                Source: PeerIQ

Ram also spoke on the Moody’s ABS Briefing Panel on Thursday, June 14th, where he spoke about how technology is changing the credit landscape and state of the consumer credit. William Black, MD Moody’s Investor Service, opened up the discussion with a review of key economic indicators and ABS markets. The slide deck is here.


Rising Rates and Inflation

The Fed raised interest rates for the 2nd time in 2018 and the target Federal Funds Rate now stands at 1.75% – 2%. The committee indicated that it would raise rates twice more in 2018, a departure from the previous stance of 3 rate hikes in 2018.

The Fed summarizes member views using the “dot-plot”. The dot plot consolidates every committee member’s estimates of rates at the end of 2018, 2019, 2020 and the for long-term. The green line shows the median estimate indicating that most Fed members expect rates to be between 2.25% – 2.5% at the end of 2018, and between 3% – 3.25% at the end of 2019.

Source: Federal Reserve, Bloomberg

Fed officials expect continued tightening until 2020, and then a lowering of rates in 2021 (coinciding with potential economic weakness from a confluence of factors such as expiring individual tax-cuts, and potential yield curve inversion).

The Fed adjusts interest rates to achieve its mandate of “maximizing employment, stabilizing prices, and moderating long-term interest rates”. US unemployment rate has reached a multi-decade low of 3.8% although the underemployment rate is at 7.6%. Most economists consider the economy to be near full employment.

Wage growth remains largely stagnant despite impressive fall in unemployment. Nominal wage growth only recently exceed the 2% mark. However, wage growth has until recently lagged the inflation rate indicating that real wages may drop if inflation accelerates further.

Source: Bloomberg, PeerIQ

Optimal Policy – Not an Easy Task

The Taylor rule is a simplified formula that estimates the neutral level of the Federal Funds Rate using the divergence in GDP growth vs potential GDP growth and inflation vs its target.

Using this simplified measure, the neutral Federal Funds Rate in today’s economy is close to 5% and the Fed has a lot of catching up to do. The Taylor Rule is generally used only as an indicative measure of the level of interest rates, but a large difference between the Taylor Rule estimate and the actual level of rates might mean that the Fed is falling behind in getting rates to their appropriate levels.

However, the Fed’s preferred inflation gauge, PCE, stands at 1.8%, approaching the Fed’s target of 2%. The PCE inflation gauge, thus far, has remained consistently below the 2% level since the Fed rate hike campaign began. The idea is that PCE readings should be evenly distributed around the 2% level; this pattern of PCE coming in consistently below the 2% level indicates Fed officials may be too hawkish.

Forward Rates – Where do we go from here?

The level of forward interest rates implies the probability of a rate hike at future Fed meetings. As the chart below shows, the market today is anticipating a rate hike at all meetings except the one in June.

Source: Bloomberg, PeerIQ

Rising front-end rates have put immense pressure on the spread between the 10-year and the 2-year Treasury yields causing the curve to flatten significantly. At ~35 bps, the 2-10 spread is at its all-time post-crisis lows.

All Eyes on the Yield Curve

A flattening yield curve squeezes lenders’ net interest margin. Rising short-rates also raises the rates on credit facilities and ABS transactions which are usually tied to a floating front-end rate.

More importantly though, an inverted yield curve has preceded past recessions and is a near-reliable predictor of an impending recession as banks are less motivated to borrow short (via deposits) and lend long.

Source: Bloomberg, PeerIQ

Reach out if you missed it or would like a copy of the webinar presentation, and visit the PeerIQ research page to download the latest Lending Earnings Insight report.

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