A storm of sorts is brewing for community bankers, perhaps not the epic “perfect storm” but one that nevertheless will present some significant challenges in maintaining profitability and margins over the coming months and well into the 2016 – 2017 planning horizon. While we don’t know when the Federal Reserve will actually begin to raise rates, whether they start this October, in December, or in early 2016, it appears that they intend to raise the benchmark overnight rate gradually over the next 24 months, by as much as 300 basis points.
The customary reasons for a central bank to raise rates are not evident in our current economic environment. The U.S. domestic economy, while performing stably, is not presenting any credible threat of overheating. Similarly, neither runaway inflation or even above target level inflation are posing threats to the economy. In fact, the risk of deflation may be greater, given current global economic headwinds, market volatility and uncertainty, the strength of the U.S. dollar, and declining commodity prices, including oil.
Today, the Fed’s primary rationale and motivation to raise rates revolves around two key points. First, the concern over extending the current high level of economic stimulus for too long a period of time, thus creating a speculative financial asset bubble, the bursting of which could get ugly. The second key point is the Fed’s current inability to lower rates in the event of an economic slowdown. Said another way, the Fed currently has only quantitative easing (QE) to stimulate a faltering economy should the U.S. domestic economy begin to lose steam. This presents an extreme quandary for the Fed which must ask “do we risk sending a prolonged weak recovery back into recession by trying to strengthen the tools needed to prevent a recession?” It’s an interesting form of Catch 22, which the Fed will clearly manage its way through in the most cautious of manners.
Assuming no major changes on the global economic front, and continuing stability or improvement of the U.S. economy as measured by consumer consumption, unemployment and inflation indicators, the Fed seems poised to begin raising rates soon and to continue that process gradually, until either they reach their three percent target rate, or the economy reacts negatively, forcing the Fed to back off on its plans for further rate increases.
If recent experience with the Fed’s rate increases bear any predictive value at all, then we should be aware that market rates, and in particular the intermediate and long-term portions of the yield curve, do not always follow the movement in rates created by the Fed in managed rates at the short end of the curve. For example, the Fed last raised the overnight rate by 4.25% between May of 2004 and July of 2006 (a 27-month time period). However, the ten-year treasury rate increased by only 50 basis points during this same time frame.
The shape of the Treasury curve in May 2004 was fairly normal with a 3.5% positive slope between the overnight and the 10-year rates. Across the 27 month rate-raising period, the curve flattened initially, and then inverted. The two prior cases of Fed rate increases, beginning in 1999 and then going back further to 1994 bore somewhat similar results. During these past three rate cycles, long term treasuries have averaged less than one-half the movement implemented by the Fed at the short end of the curve. The global economic climate today is ripe for this pattern to again repeat itself, given the strength of the dollar, global instability, and the preference for the safe haven of U.S. treasuries from bond buyers around the world. It is likely that low, long term rates will continue in the U.S. for quite some time.
What does all of this mean for community bankers today as they prepare financial forecasts for 2016? Simply stated, this translates into more margin pressure for community banks. As the Fed begins to raise rates at the short end of the curve, pressure will develop for the typical community bank to raise rates on deposits and, in particular, on money markets, interest bearing checking accounts and on short term CD’s.
Competitors with lower liquidity levels will cooperate with the market and with depositors to bring this pressure to bear on institutions that continue to have excess, un-invested funds (or under-invested funds, as the case might be). Further, lack of demand for quality loan growth will make it difficult to offset increasing deposit costs with an increased yield on loans. For the typical community bank in which the majority of the loan portfolio is in longer term loan types, generally commercial real estate loans, residential mortgage loans, or even consumer loans tied to collateral, two factors will make this improvement in yield challenging. Loan yields will remain lower than they otherwise would be due to weak demand and lower long-term rates.
Community bankers will need to assure adequate loan pricing discipline is in place to enable loan yields to keep pace with increasing deposit costs. Lenders will need to be properly armed with the systems, information and incentives to ensure that they respond appropriately to the challenges this pressurized environment creates, and to ensure that an adequate volume of new loan growth is attained in a highly competitive marketplace.
