Jim Reber: Manage Interest Rate Risk With Strategic Portfolio Decisions

Let’s start this month’s column with a dose of banality: Be careful what you wish for. For at least four years, all manners of bond market participants—including analysts, consultants, pundits and, not least, investors—have been predicting and hoping for a normally sloped yield curve. Though the longest-on-record inversion finally corrected itself last September when the Fed first cut rates, we did not see a positive slope of even 50 basis points (0.5%) until May. (Trivia fans: The average difference between twos and 10s was a nice neat 100 basis points for the past 15 years.)

Most community bankers I’ve spoken with this year have been hoping for a steeper curve. Even though the interest rate risk of most banks is well insulated against relatively small rate shocks, the feeling is that a more normal curve shape would help loan officers and liquidity managers to price relative risk. Aligned with this is the notion that we’re in a secular falling rate environment, as evidenced by Fed funds futures that have been projecting between one and four rate cuts by the end of 2025.

And now? Wholly unrelated to economic factors come trade policy and fiscal issues to drive interest rates. It’s possible the Fed will stay on the sidelines for a good long while. And the yield curve? It’s gotten some slope all right—compliments of a “bear steepener.” 

What it looks like

Bear steepeners are interest rate maneuvers in which rates rise and longer tenors increase more than shorter ones. They are relatively rare, as most of the time the curve steepens, it’s the result of anticipated or actual rate cuts by the Fed. Why is this? First, I should repeat myself (hackneyed again) that all rates have trended lower since the 1980s, the past three years notwithstanding. Also, think about what the Fed is trying to accomplish when it employs rate hikes: It is trying to slow down the economy and/or stamp out inflation. Both of those are reasons for the curve to flatten. 

And now? Longer investors (say five years and more) are highly concerned about inflation reigniting and about the projections of escalating national debt. The Fed for its part is having to take a wait-and-see approach, so it’s wholly unclear when or if it will make a change to monetary policy. The result is the 2025 bear steepener, in which the longest rates are hitting multiyear highs. 

2013 hissy fit

In the lexicon of veteran portfolio managers and community bankers is the “Taper Tantrum.” This came about in 2013, when the U.S. economy was still working through the Great Recession. The Fed, then chaired by Ben Bernanke, was in the middle of a quantitative easing (QE) phase of buying a lot of bonds in the open market. The chairman made some comments about slowing down the scale of the purchases, which the market was not expecting, and longer bonds had a hard sell-off. The 10-year note’s yield rose well over 100 basis points in four months, and all the while, the Fed was still into QE. 

It turned out the Fed didn’t taper its purchases for over a year following the bombshell press conference. In fact, its forward guidance continued to suggest an accommodative monetary policy. Bond market yields eventually retreated to pre-Tantrum levels, as inflation never reared its head. That period of history remains a benchmark example of a bear steepener in the fixed income market. 

What could work

What if short rates remain anchored at or about where they are now and longer rates remain annoyingly elevated? First, and to stay on the vapid track, I’d like to point out the obvious. Your community bank’s bond portfolio will continue to be underwater, and mortgage lending will remain a challenge. Cash flows from your mortgage securities will be limited, and not many bonds will be called away by the issuers.

Finally, for some good news: It’s possible that longer-duration securities are reaching the point of being oversold. The 30-year Treasury has touched levels in 2025 that haven’t been seen in 18 years. If the Fed is forced to delay rate cuts, floating rate securities could offer relative value, even if the yield curve has some slope. 

The suggestion therefore is a tried-and-true strategy: the barbell. Roughly equal amounts of short and long bonds, employed in this uncertain environment, will likely produce some tactical wins. To conclude, here’s one more cliché: “Slow and steady wins the race.”