On Friday, August 23, during the Federal Reserve Bank of Kansas City's annual conference in Jackson Hole, Fed Chair Jerome Powell indicated that the Federal Reserve was ready to decrease rates.
Specifically, he said, “The time has come for policy to adjust.” He continued, “The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
While the direction is “clear” in most market participants’ minds, the pace and degree to which the FOMC reduces rates are fodder for great debate.
Nonetheless, financial institutions now need to pivot their strategies as the FOMC presumably embarks on an easing cycle.
For those thinking through some of the key considerations for managing their balance sheets in the early stages of a Fed easing cycle, I’d highly recommend the most recent episode of DCG’s On the Balance Sheet® podcast aptly titled “Falling Rate Fever.”
Co-host Zach Zoia and I were joined by our veteran DCG colleague Frank Farone, who has been through several rate cycles himself. Frank did well to remind us of how human behavior has a way of repeating itself.
Our discussion centered on five key themes:
1. CD Rates
Retention costs might be lower than you think: Certificate of Deposit rates commonly offered at 5% or higher are now trending lower, even though the FOMC has not yet decreased rates. Many institutions find that they are successfully retaining deposits even as they lower rates below competition. Frank emphasizes that banks and credit unions should think through the incremental reductions to CD promotional products to take advantage of these lower rates. Frank also suggests that institutions rethink the terms they are offering in light of the market’s future expectations for interest rates. Allowing for faster rollover at lower rates may be beneficial in a falling rate environment, as it provides flexibility and lowers overall costs.
Importance of a data driven strategy: The guys discuss the importance of leveraging empirical data to support strategy, as opposed to simply pricing to what the “irrational” players in local markets are up to. The reality is that deposit strategy should not be driven by a few “disgruntled rate shoppers” when the preponderance of the deposit base is acting differently. A data-driven strategy helps eliminate bias from pricing by creating parameters based on fact, not emotion.
Consider the alternatives: Clearly, liquidity was the main concern for most financial institutions throughout this rising rate cycle. Fortunately, it appears as if the rate at which deposits were leaving the industry has slowed significantly. For a few, deposits may even be growing again. While many welcome this stabilization, the cost of retail liquidity remains elevated. However, wholesale market rates are now offering a glimmer of hope given the rally in the long end of the yield curve. Therefore, institutions need to consider the cost of alternative funding when replacing maturing CDs.
2. Non-Maturity Deposits
Overview: Frank reminds us that “human behavior tends to repeat in rate cycles, both among bankers and consumers.” To that point, Frank refers back to 2007, when the average community bank had a 60% / 40% mix between NMDs and CDs, whereas that ratio (Pre-COVID) moved up to 85% NMDs / 15% CDs. Frank contends that the assumption of CDs migrating back into NMDs during this falling rate environment might be incorrect, and that CD levels may in fact remain higher. Frank asks institutions to look at their total betas through the most recent cycle and evaluate whether or not they will be able to move those betas back down through a falling rate cycle (if they didn’t move up to degree assumed).
Grabbing nickel and dimes: The guys also discuss the idea of “grabbing nickels and dimes” from the NMD base by slightly reducing select accounts that demonstrate less rate sensitive behavior patterns and therefore may be indifferent to minor rate reductions. All agree on the critical importance of data to contextualize a pricing strategy
The time is now: Frank reminds us of the importance of being proactive versus reactive. Given that the FOMC is likely reducing rates on 9/18, the time to develop and implement a strategy for the following day is NOW!
3. BTFP (Bank Term Funding Program)
Prepaying BTFP: Frank mentions that for banks that have BTFP money at a rate below Fed Funds, they still have a “free put option.” He highlights that some institutions are using an arbitrage strategy—borrowing at lower rates (e.g., 4.25% brokered CDs) and investing the funds in short-term instruments (e.g., Fed Funds) at a higher rate. In effect, an arbitrage on top of an arbitrage. For some, their capital position doesn’t warrant this strategy, but for others more acutely concerned with earnings, this is a strategy some have executed.
Using swaps: Institutions with access to derivatives, such as interest rate swaps, can use these tools to manage their funding costs more effectively and maintain flexibility. Swaps may allow banks to lock in lower funding costs or extend liability durations without increasing balance sheet risk.
4. Loan Repricing and Derivatives
Loan prepayment risk: Many banks that issued loans during the past 15-18 months at higher rates now face the risk of prepayment as rates decline. More than likely, when the Federal reserve lowers rates, the media at large will “pick it up” and customers less inclined to follow the bond markets may realize they have a chance to reduce their rate. Banks should quantify their potential risk of refinance activity by stratifying recent coupon levels on originations and ensuring that lenders responsible for those relationships are equipped to handle potential discussions.
Prepayment provisions: Frank discusses how some institutions offer no prepayment penalties for refinancing within their organization. While not always enforced, there is significant financial value that can be derived from appropriately designed prepayment penalties. Furthermore, simply understanding the financial value of these options in the financial markets can go a long way toward determining pricing on new deals.
Using derivatives for loan management: Institutions can look to the use of derivatives, like pay-fixed interest rate swaps, to convert fixed-rate loans into floating-rate assets. This strategy helps mitigate interest rate risk and reduces the need to offload loans at unfavorable terms.
Missed opportunities: Frank points out that many institutions have missed the chance to use derivatives effectively during previous rate cycles. He encourages banks and credit unions to prepare for the next rate cycle by incorporating these financial tools into their loan pricing strategies.
5. Investment Portfolio Management
Timing of bond purchases: Banks often hesitate to buy bonds when the yield curve is flat or inverted, instead opting to wait for some level of steepening. However, Frank argues that some of the best bond purchases are made when there is little or no spread between long-term bonds and short-term rates, typically during an inverted yield curve.
Cycle timing: Frank explains that long-term rates tend to move ahead of short-term rates during rate cycles. Waiting for "the perfect time" to buy bonds can result in missed opportunities, especially after significant rate increases.
Dollar-cost averaging: Frank advises institutions to consider dollar-cost averaging by replacing maturing low-yielding bonds with higher-yield bonds in phases rather than waiting for a significant rate drop. This allows institutions to maintain protection against future rate drops while taking advantage of current market conditions.
Protecting against future rate drops: Even though some may feel that it’s too late to invest in bonds given the current rate environment, Frank argues that rates often fall faster and further than expected. Institutions should still consider building a position in higher-yielding bonds to protect against future declines in rates.
Summary
On July 28, 2021, Jerome Powell first described inflation as “transitory.” Just four months later during a press conference, he acknowledged that the term was no longer appropriate. Clearly, a lot can change very quickly. As we know, the Fed increased rates by 525bps and left the curve inverted to this day.
And now, as we publish this Bulletin, the Fed Funds Futures markets are predicting that the Fed Funds Rate will be down by 100bps from current levels by the end of 2024. Furthermore, the probabilities in those markets are suggesting the Fed Funds rate will be sub 3% by year end 2025. As most already know, the track record of the forward curve isn’t very reliable.
So, what ultimately happens to interest rates is really anyone’s guess (including the above two parties).
However, as balance sheet managers, we need to be prepared for all the possibilities.
For those who couldn’t “join us” on the podcast and prefer the “CliffsNotes® version,” we hope the above summary will prepare your institution for an evolving interest rate landscape.
For more insights from Darling Consulting Group, click here.
ABOUT THE AUTHOR
Vinny Clevenger is a Managing Director at Darling Consulting Group. In this position, he advises financial institutions on balance sheet management strategies. He takes a practical approach to the demands that the economic and regulatory environments place on his clients. Since joining the firm in 2003, he has worked in a number of capacities within DCG assisting clients in all aspects of ALM, including process reviews, model validations, policy reviews, capital management, and contingency liquidity planning.
He serves as the editor for the monthly DCG Bulletin as well as co-host of DCG’s On the Balance Sheet® podcast.
Prior to DCG, Vinny worked in public accounting. He holds a B.S. in accounting from Merrimack College in North Andover, MA, where he served as captain of the Men’s Division 1 Ice Hockey Team.
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