With October upon us, many things come to people’s minds. The changing of the fall foliage, football tailgates in full swing, the return of pumpkin spice lattes, celebrating Halloween, and, last but not least, budget season.
Given all that has transpired over the past two+ years – runaway inflation leading to the fastest pace of Fed rate increases in over 40 years, market volatility, deposit/funding and liquidity pressures, bank failures, and sustained yield curve inversion – I couldn’t help but find an interesting parallel between preparing the 2025 budget and the traditional Halloween phrase “trick or treat.”
From the Editor
My most memorable Halloween occurred in a custom California Raisin costume. In the pre-Amazon days when costumes had to be curated by hand, we cobbled together some chicken wire, burlap sacks from bags of potatoes, a couple of hula hoops, and some spray paint to get the job done. I even borrowed white gloves to complete the look.
While I was incredibly excited to “show off” my costume, I quickly realized it was a big mistake on my behalf. Trick or Treating in a hilly Pennsylvania neighborhood with other young boys turned me from a raisin into a rolling projectile! Chicken wire doesn’t feel great when rolling uncontrollably down hills.
In a way, it must feel exactly like what budgeters have felt over the past couple of years. No matter how well-prepared, intentioned, or researched your projections might have been, for the most part they likely missed the mark. The budgeting version of an ill-advised California Raisin costume!
In this month’s Bulletin, DCG Director Ryan Gilles compares budgeting to Trick or Treating. He outlines what factors might emerge as “treats” for institutions (deposit stability, improving asset yields, steepening yield curves) versus potential “tricks” (loan growth, degree of deposit cost reductions, etc.).
I’d highly recommend a quick perusal of Ryan’s overview to help with the budgeting process this fall. Maybe the 2025 budget will go exactly as planned, filled with “treats” for all of us – or maybe something will “trick” us once again. Happy Halloween to all!
Vin Clevenger, Managing Director
While “trick or treat” is commonly thought of as just a phrase costumed children say to get candy from their neighbors, I find myself thinking that budgeters may be asking themselves, “Trick or treat?” while trying to put together this year’s assumptions.
This is especially true after the Fed officially put an end to the recent tightening cycle by cutting rates by 50bps in September and provided an outlook for the potential of an additional 150bps of rate cuts through the end of 2025.
While markets are pondering how much the Fed will actually cut rates given some choppy inflation and jobs data, the reality is that someone at every financial institution is responsible for creating their best estimate of market developments over the next calendar year.
To help those crafting their budgets in the coming weeks, I thought it could be helpful to apply “trick or treat” to some of those budget assumptions.
Market Rates
Trick: What may institutions assume for market rates throughout 2025?
While obviously a loaded question, most folks look toward some combination of the forward implied yield curve, market and FOMC projections to determine what to budget for rates.
While we know that these sources can’t predict the future, they may still be the best “guess” as to where market rates may go from here. Given the potential for future economic data to influence the Fed’s plans, it may be worth several iterations utilizing the forward implied curve and another version that may assume a slower pace of Fed rate cuts to account for what could happen if economic data starts to trend away from Fed projections.
Treat: The intermediate portion of the yield curve has become dis-inverted (2-10 spread no longer negative). What does this mean for my institution?
One of the biggest challenges for financial institutions throughout this tightening cycle has been the inversion (both the length and the magnitude) in the yield curve. Fortunately, the tide has begun to turn with the curve starting to “uninvert” on the long end. Historically speaking, this aligns with what typically occurs early in a falling rate cycle. Longer-term rates traditionally move lower in anticipation of Fed action (please see the table below comparing the yield curve from June to August – just before the Fed cut rates) but then “stabilize” as short-term market rates ultimately fall below and a positive slope to the yield curve returns.
In this scenario, falling rates may allow institutions to keep loan pricing close to current rates while having more ability to decrease deposit costs.
However, this time might be different. In the wake of the Fed’s Sept 50bps rate cut, longer-term treasury rates have rocketed from approximately 3.60% up to 4.30%. This scenario may further improve margins for financial institutions as asset yields might actually get a boost, whereas deposit costs are on the decline!
Funding
Trick: Since the Fed cut rates, institutions can make wholesale changes to deposit costs.
For most institutions during this cycle, DCG observed a few primary tactics on the pricing side: 1) offering attractive CD specials to retain balances, even if it meant shifting from NMDs into CDs, 2) rolling out a premium savings/MMDA to keep NMD funds where they are but paying a rate that they wanted to keep the funds there, and 3) some combination of both. When considering betas in DCG’s Deposits360°® Cross-Institution database throughout this past tightening cycle, it’s clear that the major rate increases occurred in CDs and MMDAs.
Source: Darling Consulting Group Deposits360°®
For premium/exception priced NMDs, these rates may need to be dropped lower, but the question is how much lower?
Since the industry lagged NMD rate increases for the first 150bps as rates increased, will there be some level of lag effect on the way back down? This may vary for all institutions and be heavily influenced by current liquidity positions. Perhaps lagging further than peers may lead to some deposit growth and reduce some liquidity pressures for those who have them? Or do institutions have wholesale capacity and are they comfortable with potential deposit volatility as rates drop?
CD pricing has been moving lower for the past few months. DCG has observed many groups push their CD rates into the 4.50% range (and below) without seeing much slippage in balance retention. So, if the FOMC moves as currently expected, how low can an institution go? Should an institution risk disrupting rate-sensitive depositors or has indifference set in amongst that subset of the funding base?
Treat: Deposit balances are showing signs of stabilization.
One welcomed trend has been that deposit balances have stabilized for most. While some may still be experiencing mix shifts out of NMDs into CDs (albeit at a much lower velocity), NMD balances have become much more stable in recent months, which has helped earnings/margin pressure and stabilized liquidity profiles.
Growth figures for 2025 will certainly be influenced by the selected rate strategy, but the potential for deposits to grow or at least hold flat seems as promising as it has in the past several years.
Lending
Trick: After seeing loan pipelines slow considerably in 2024, what is the prospect for loan growth?
While this question is heavily influenced by individual market(s) demand, the type of lending an institution does (commercial vs. residential, fixed vs. floating), and how it reacts from a pricing standpoint, the range of outcomes still “feels” really wide.
Will businesses or consumers remain patient for rates to move even lower before starting to borrow again? What about the potential for increased payoff activity to wipe away net growth from new originations? Will credit quality continue to hold up? All of these will ultimately play a role in determining what the lending outlook looks like for an institution – and it sounds like a lot of variables to plan for which once again makes budgeting loan activity difficult.
Treat: Even though the headlines read “rates are moving lower,” does that really mean loan pricing should, too?
This will depend on whether an institution is a fixed or floating rate lender. Those with large floating rate loan portfolios may face some downward pressure on pricing as the short end continues to move lower.
However, for the longer-term fixed rate deals, continued discipline on the pricing side is essential. If an institution is pricing loans off the longer end of the curve and doesn’t see much downward movement on those rates, the loan pricing should reflect that by not seeing much downward movement from current levels.
While competition might influence pricing, institutions should consider establishing their tie-breakers and trade-offs for loan pricing moving forward. In an environment where liquidity remains at a premium and credit issues could be lurking around the corner, it’s critical to ensure adequate compensation for the risks of lending money.
Investments
Trick: Avoid playing “Monday morning quarterback” on not buying into the market at the peak of rates.
While hindsight is always 20/20, there will definitely be some who will wish they had bought securities when the 10-year UST was in the 5% range. However, it’s important to remember the reasons for not making those decisions at the time. For some, it could be the feeling of being snakebitten by unrealized losses swelling over the past few years. For others, it could be that it was hard to rationalize adding more wholesale funding at high costs to execute a leverage transaction at a minimal spread right out of the gate, or making tight liquidity positions even tighter. Or maybe it was due to stronger loan demand at the time being the primary focus of asset growth. Regardless of the rationale, playing Monday morning quarterback won’t help other than learning from it and moving forward because…
Treat: There are still attractive options in the marketplace.
Buoyed by the recent market sell-off, there are still securities that come at discounts that may provide some nice falling rate benefit if prepayments pick up and the institution gets to accrete the discounts quicker (or could sell at gains).
Especially for those who have seen loan demand dry up a bit, the bond portfolio could still provide a nice opportunity to add falling rate protection with new bond purchases or even just to start to reinvest cash flow back into the market today.
Another consideration for future purchases is the regulatory viewpoint of liquidity. Operating and contingency liquidity continue to dominate recent examinations, so adding to the investment portfolio today may not only augment earnings and alleviate falling rate exposure, but it may also provide a nice boost to collateral-based funding access by pledging new securities to the FHLB or the Federal Reserve to increase borrowing capacity.
While the annual budget exercise can feel as comfortable as “trick or treating” around a dark neighborhood with a bulky costume, weird mask, and bucket loaded with candy, we hope that some of these insights will help you find more “treats” and avoid the “tricks” when building the 2025 budget. Happy Halloween to all!
For more insights from Darling Consulting Group, click here.
ABOUT THE AUTHOR
Ryan Gilles is a Director at Darling Consulting Group where he assists community financial institutions throughout the U.S. to solidify and enhance balance sheet management. In this role, he works collaboratively with executive teams and ALCO committees to help develop and implement tailor-made strategies related to interest rate risk, liquidity, and capital while prudently managing risk to optimize earnings and satisfy regulatory compliance.
Ryan began his career at DCG in 2013 as a financial analyst and continues to work closely with the implementation and ongoing education of DCG’s decision-support tools (Deposts360°® and Prepayments360°™) as well as onboarding and building out new client ALCO models with the New Client Implementation team. He currently lives in South Boston with his wife and is a graduate of Assumption University with a B.A. in Accounting.
© 2024 Darling Consulting Group, Inc.
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