On Weds. the FOMC cut the target Fed Funds and discount rate by 25bp. In addition, members of the Fed effectively told the public that while they are closely monitoring conditions, the markets should not expect another rate cut any time soon.
In general, we don't like the latest move as we think inflationary pressure has become a greater concern than growth. Today's employment report, high GDP, a weak dollar and a still strong consumer point to some modicum of underlying support. As such, our updated view is that the Fed is done until at least 1Q of next year and that there will be more upward rate pressure in the interim than lower. The question is - what are banks to do?
The first step is to select a rate view. Banks should then assign probabilities to different scenarios, in order to test 2008 budgets and strategic plans. We see a 25% chance that rates rise 100bp from here, a 55% chance that rates stay within a tight 50bp range and a 20% probability that rates drop more than 50bp. Whatever the probabilities you assign, the view you select will serve as a basis to test potential loan performance, create a staffing plan, make capital decisions and drive growth.
The second step we suggest is to cut deposit rates by 20bp to 35bp while increasing pricing discipline. On average, 43% of bank assets reset lower this week. Meanwhile, an informal poll we conducted, found only 20% of banks moved their deposit rates down. Those that did moved money market and CD rates lower by an average of 10bp. For many, this lag and lack of relative action may guarantee lower 4Q earnings if management isn't careful. Since August, rates have moved down almost 100bp, giving bank management excellent insight into deposit rate sensitivity. On average, banks could gather more deposits (at cheaper aggregate levels) by lowering rates on commercial accounts by 35bp and retail accounts by 20bp. Due to related sensitivities, the average bank would increase deposit performance. That said, your bank most likely differs from average, so take a look at the data and see what it is telling you.
The third step is to ramp up marketing and sales for deposits. Greater market volatility, the lack of consumer confidence and falling equities all play into the safety and soundness of a bank's brand. Certain segments, such as title companies and 1031 exchange firms, are poised to see their deposit balances increase should rates stay low. Since community banks pride themselves on service – get out there and start suggesting strategies to your commercial customers on how to take advantage of the market.
The fourth step is to focus on loans. Lower rates and a steeper curve make fixed rate loans more attractive to borrowers. This trend will likely be exacerbated in coming months, as the threat of inflation raises long term rates (creating the need for certainty in many clients' debt structures). Since many conduits have reduced their fixed rate loan demand, pricing is now up 75bp in the 7Y and longer area since August. Banks should continue to take advantage of this reduced competition by finding ways to originate longer-term fixed rate loans. Additionally, a growing divergence in default data among loan types and shifting interest rates, have made a loan pricing model mandatory. Optionality, expected defaults on retail CRE, multifamily and other areas have all shifted in the last couple of weeks. Banks need to take these latest trends into account if they are to maintain suitable risk-adjusted ROE over the long-term.
Finally, publicly traded banks should be aware of a relatively new phenomenon. Since July, quantitative investment funds have attempted to arbitrage the markets by going long the technology sector and shorting banks. Those banks that are in various indices have seen huge short positions appear on their stock for no other reason than they are liquid parts of the industry. Improving core performance and spending more resources on investor relations will cause these short position players serious pain.
If you would like assistance on any of the above or would like to receive our monthly "ALCO Package Update", contact us.