The Federal Open Markets Committee (FOMC) today announced another super-sized interest rate hike, raising the target Fed Funds rate by 75 basis points (bp) to a range of 300 bp to 325 bp. Prior to the August inflation report, futures markets indicated an expectation that the Fed might begin to moderate the pace of hiking. But with prices of many goods and services continuing to rise, the FOMC has kept the pedal to the metal on monetary tightening.
Price pressures and rising rates aren’t isolated to the U.S. Since our last FOMC Perspective in July, we have also seen the Bank of England hike rates 50 bp in August, with another 50 bp expected tomorrow (Sept. 22). The European Central Bank and the Bank of Canada hiked rates by 75 bp in September and the Reserve Bank of Australia raised them by 50 bp in both August and July.
Questions for central bankers, market participants and consumers remain: When will inflation peak? What collateral damage will higher rates inflict on financial markets and the real economy as a byproduct of these inflation-taming measures? Most simply: will the Fed thread the needle and execute a “soft landing” or will it take a beyond-technical recession to break the back of inflation? And how will exogenous factors, including potential European energy shortages, impact global supply chains and markets?
Forming a point of view on these questions is critical to managing deposits in an increasingly dynamic market. The adage holds true that it is generally cheaper to retain an existing customer than to win a new customer. But with widening divergence between the liquidity “haves” and “have nots,” the market pricing for marginal reserve dollars — both in commercial and in the most rate-sensitive consumer pools — is becoming costly for banks. Top direct bank rates and prime institutional money market fund yields are north of 2% prior to today’s rate hike and the competition for the most rate-sensitive slice of liquidity has been painful. Banks that can afford to have, so far, generally taken the position of letting this money leave. This is evidenced by commercial MMDA balances that are down 15.5% year over year. The pace of retail switching into higher-rate products has nearly reached levels observed in 2019. Institutions that believe we’re headed for a soft landing will want to pay up now to keep these balances. Those that anticipate a broad-based slowdown over the next few years will let the balances walk out the door and re-group to patiently raise quality funding for the next cycle.
The big shoe that could still drop is repricing of core operating deposits. While tightening monetary conditions have dented core checking growth in both consumer and commercial, balances have generally been stable, and these books have yet to materially reprice. Retail back-book rates remain relatively unchanged and commercial ECR betas are in the low-single digits. But the question is, can this hold with Fed Funds now above 3%?
In summary, with more balances in movement, banks face a critical choice on which balances they pay to retain and which they usher toward the exits. Both the quality of the current funding book and the outlook for future funding requirements will guide strategy. Given the macroeconomic uncertainty in play, it is critically important that banks consider a range of sound and analytically-informed forecast models to guide their deposit strategy through the coming months.
Commercial Focus: Rate-Seeking Money Is Voting With Feet, While Operating Accounts Remain Stable
Commercial balances continue to bleed out as the most rate-sensitive money moves to off- balance sheet money funds. Total commercial deposits are down more than 6.1% year over year while MMDA balances are down considerably more. We expect more outflows to follow as the impact of quantitative tightening continues to propagate through the system and banks flush with liquidity decline to offer fully-indexed rates on the most price-sensitive balances.
Despite laudable discipline from top quartile performers, industrywide betas have continued to move higher on interest-bearing deposits. Cycle-to-date interest checking betas were 29.5% as of August while MMDA betas were up to 34.6%. These increases have accelerated with recent hikes and put portfolio betas on a trajectory to reach the 40% range by year end. (See Figure 1.) The two factors that could potentially accelerate betas include more widespread competition for the most rate-sensitive reserve balances and broader re-pricing of the back book.
There has been very little remixing of ECR balances into interest-bearing alternatives and, as a result, ECR betas remain remarkably low at less than 5%. This ultra-low beta is consistent with the prior cycle but is contrary to what many liquidity managers expected at the start of this rising-rate cycle. This could change quickly, however, especially as companies begin to realize the impact of more ambitious bank price increases on payments services, many of which will take effect between now and the end of the year.
In conclusion, looking across the universe of commercial portfolios, this cycle is putting an emphatic proof point on the value of more granular portfolios of primary operating accounts. The single largest factor separating those with low commercial deposit portfolio betas and those with high betas is the percentage of balances in smaller operating accounts. And for many banks with higher portfolio betas, a key driver is concern that some of the deposits they had presumed to be operating were in fact reserve balances. Remixing a commercial deposit portfolio from reserve to operating isn’t something that a bank can do overnight. Rather, it is the result of a disciplined approach towards acquiring, deepening and retaining primary relationship clients to drive through the cycle value.
Figure 1: Average Commercial Portfolio Rate
Retail Focus: Inflection Point Is Here
As the Fed passed 2.00% and now passes 3.00%, it’s clear that more retail customers are now seeking higher rates. The share of new money going into CDs at traditional banks has increased by 250% since March, with a majority of CD volume now at rates above 0.75%. Additionally, switching behavior — both internal moves to higher-rate products and external moves to online banks – has nearly reached levels observed in 2019.
Meanwhile, inflation is continuing to exert downward pressure on retail deposits, with checking balances down more than 3% since the end of April and savings deposits down as well — particularly in lower-balance accounts where customers are dipping into their reserves. (See Figure 2.) The net effect is that, for the first time, both mass market and mass affluent deposit balances are under pressure, driven by inflation and yield-seeking customers, respectively.
Even as we are seeing increased rate-driven behavior, two questions stand out:
First, why did it take retail consumers so long to react to higher rates? It is worth remembering that while the Fed is already past the high point of the last cycle, it is only six months since the first increase (which was only 0.25%) and only four months since the Fed passed 1.00%. In the last two cycles, the lag in consumer behavior lasted for the first three to four Fed increases, each of which was a 0.25% increase. In this cycle, the lag similarly lasted for the first three to four increases, despite the last two increases before today being 0.75%. For the consumer who isn’t accustomed to thinking about interest rates and is perhaps more worried about the day-to-day impacts of inflation, the time duration of the lag remains quite typical to history.
Second, how intense will yield-seeking behavior get? History would suggest a steepening ramp as we pass more benchmark rates. With the Fed passing 3.00% and online banks above 2.00%, history suggests further increases in yield-seeking behavior. Additionally, as more customers begin to seek yield, banks will need to respond to a greater extent in order to retain deposits. Increasing rates then drives continued churn as customers shift internally and see higher rates at competitors, driving bank-to-bank churn as well.
With continued pressure from both inflation and yield-seeking churn, the risk of continued retail deposit runoff through the end of 2022 and into next year is real. Banks will need to determine how much runoff is acceptable and how high they are willing to raise deposit rates in order to save balances and relationships.
Figure 2: Consumer Deposit Growth | Q2 2022 (Apr–Jun)
Home Lending Focus: In Search Of Affordability And Niches
The mortgage market is both blessed and cursed due to its out-sized sensitivity to changes in interest rates. (See Figure 3.) This is primarily due to refinance transactions where borrowers have become well-conditioned over the past decade to take advantage of falling interest rates and have done so with great enthusiasm.
Now, after many homeowners locked in mortgage rates when they were in the range of 2% to 4%, it is almost out of the question to think about refinance rates at around 6%, even when considering cash-out transactions. Over the past few months, Curinos has examined the rush to second-lien home equity loans and lines that have resulted from the significant rise in home values and availability of credit.
Where does that leave the first mortgage market, with its sole focus on home purchase financing? The answer is that mortgage lenders are searching their cupboards and dusting off all manner of loan products. We are seeing a reemergence of 40-year term loans, “non-QM” (non-qualified mortgage) loans, reverse loans and all types of adjustable-rate mortgages (ARMs). Some of these products are aimed at addressing affordability, while others are niche products that are aimed at expanding the universe of eligible borrowers.
One lending giant recently announced a zero-down payment initiative for targeted markets. Another offered a program that entices home buyers with pre-arranged refinance discounts if rates come back down. Major lenders have also preemptively increased loan limits for GSE-eligible loans to $715,000 (an increase of roughly 10%) over two months before the government even determines the maximum loan amount!
The question, of course, is whether these market developments will spur additional mortgage originations or whether higher rates will indeed slow the red-hot home purchase market. And, at the same time, can lenders that seek to boost their share of the mortgage market do it without taking on undue credit risk?
Figure 3: Mortgage Volume Velocity
Digital Focus: Is It Time To Change The Channel?
Should one channel take preference because of a business case or a nifty innovation? It’s a question banks tackle and review continually, but it is the customer’s preference that should at the heart of the answer. And in some cases, the desktop may be the channel of choice.
Channel preferences have changed a lot for business and retail checking customers over the past few years. The ebb and flow of economic discomfort that many of them now face suggest banks will need to make razor-sharp decisions about which channels are delivering better value to users. Then, they need to make them more effective.
App developments and app investments have taken priority in this new digital era as many market participants try to encourage everyday in-app engagement and complete banking experiences on mobile devices. Spurred on by competition from the fintech community, incumbents continue to roll out interesting functionalities, from ATM cash withdrawal capabilities via a QR code on the app to full budgeting and saving software. In the business-banking world, leading providers now offer everyday corporate requirements from expense management to full bookkeeping tools.
Consumer and SMB banking providers are adding even bigger functionality to apps, including the integration of loan and mortgage applications and bulk payment capabilities.
But banks would be wrong to consider this the death of the desktop. Quite the opposite, in fact. More business banks have started promoting omnichannel engagement, while retail providers acknowledge that investment in desktop will be the only way to retain large swaths of some customers in certain demographics, including those with accessibility issues (desktops have larger screens that are easier to read, for example). Although the statistic has been dropping over the past decade, nearly half of all internet usage in the U.S. still takes place on desktop.
Channel management is becoming increasingly problematic for banks’ digital teams – and it’s not just the distinction between desktop and app. There is more investment pouring into wearables and there is a need to monitor other innovative UX developments, such as those currently anticipated with the metaverse.
That means it will be more important than ever for providers to have a clear omnichannel road path – with agility built in so that they can change direction with shifts in economic conditions and customer preference.
