As expected, the FOMC in September held the Federal Funds rate flat in a target range of 5.25% to 5.50%. The process of balance sheet reduction (quantitative tightening) will continue at the previously communicated rate of $95 billion per month.
Going into the meeting, markets were discounting that the Fed Funds rate is at or near the peak for this cycle, and that the FOMC will keep rates flat +/- 25bp through the first half of 2024 before beginning a gradual downward trajectory, with year-end probabilities centered around a range of 4.5% to 4.75%. The FOMC members’ own projections, based on their “dot plots,” are somewhat more hawkish, with a slim majority suggesting that the Fed Funds rate will remain above 5% though the end of 2024. As always, Chairman Powell stressed that future decisions will be taken one meeting at a time and will be guided by the data.
Rising-rate cycles are typically an opportunity for banks to grow net interest revenue. To date, this dynamic has held to an extent, but this rate cycle is complicated. Aggressive monetary tightening has shrunk the total deposit pool, commercial betas have pushed well beyond peak levels of the prior cycle, and consumers have poured funds into CDs at scale for the first time in more than 15 years. Moreover, technology has accelerated behavioral changes in both commercial and consumer segments. Depositors have faster access to information and can easily move funds to manage risk or optimize return. The result is higher-than-expected funding costs that pose a profitability headwind for most banks.
Despite the challenges, there appears to be a sense of complacency among many bankers who feel that a Fed plateau will ease the pressures on deposit betas and balances. We’ve seen this in recent public comments from bank executives as well as in Curinos survey data from bank liquidity managers.
Our advice: caution. Market conditions consistent with stabilizing deposit levels typically also indicate rates above the high end of forecasted ranges. Moreover, prior cycles show that deposit betas continue to move upward even after the Fed Funds rate hits its cyclical peak. There are still significant lower-cost deposit back books in both commercial and consumer, and in the next two quarters, the industry will have to manage through the first significant tranche of retail CD maturities in well over a decade.
To be sure, much of the recent data is encouraging, including improvements to both consumer and commercial deposit balances over the past couple of months. But those improvements have come at a cost: betas have continued to move higher as CD offers and commercial exception rates above 5% have become increasingly common. In a prolonged Fed plateau, we believe banks will have increasingly hard choices to make when it comes to balancing funding levels with the costs. And because it will have a significant strategic impact on bank earnings, this balancing act will require careful forecasting and business planning.
Commercial Spotlight: Three (Or Four) Dimensional Chess
Within their deposit portfolios, commercial bankers have been balancing three distinct dynamics that are driving overall performance: exception pricing on the interest-bearing portfolio, where to set earnings credit rates (ECR) and the impact of rotation from non-interest-bearing to interest-bearing products. Taken together, these are the three factors that drive both balance levels and interest expense across commercial portfolios. A fourth factor – pricing for payments services, which is not typically controlled directly by the liquidity manager, influences both product rotation and total relationship economics.
Managing each of these factors has presented a challenge over the last year. On exception rates, banks must decide when to compete for the most rate-sensitive balances when doing so requires betas of nearly 100% to prevent the funds from moving to off-balance sheet cash alternatives. ECR deposits still account for a third of commercial balances despite being a relic of Regulation Q, which was repealed over a decade ago. Customers staying in ECR accounts have been willing to accept much lower compensation for their deposits relative to what they’d earn in an interest-bearing account. In fact, cycle-to-date betas on ECRs are only 10%, versus 66% in money market demand accounts (MMDA). This is a market inefficiency that so far has come down in favor of banks. While these balances have been instrumental in holding down total portfolio interest expense cycle to date, more and more customers have been switching balances into interest-bearing products to take advantage of better overall relationship economics.
In a potential Fed plateau, the question becomes, “How will these dynamics play out?” If prior cycles are a guide, the material back books of deposits that banks are still sitting on will continue to reprice even after the FOMC stops hiking rates. And if the one-third of commercial deposits sitting in ECRs (most earning rates well below 1%) continue to shift into interest-bearing deposits, rates will go still higher.
Our cautionary view is that bankers will likely be forced to make tradeoffs between managing commercial balance levels and holding the line on portfolio interest expense. In this or any challenging environment, the best management tools are dynamic relationship profitability models, which are most effective when a bank has meaningful payments volumes that allow for pricing optimization across both deposits and fees.
Retail Spotlight: "Filling The Gap" May Run Out Of Gas
Throughout the rising-rate cycle, many banks have used retail deposits to “fill the gap” – either to close a growth gap as commercial and wealth deposits saw higher runoff or to close a margin gap as commercial and wealth deposits repriced more quickly. Curinos projects that industry growth will continue to face headwinds, and without the cushion of rising rates to increase margins, filling the gap is likely to become much more difficult in 2024.
From a growth perspective, the last 18 months have presented a stark change from historical levels of 4% to 7% annual growth for consumer deposits. Overall, they’ve been declining modestly, especially in branches, where they’re down 3% to 4% year over year. This runoff has been driven largely by inflation and spending, with checking and savings deposits seeing a steep decline. Rate-driven churn has largely remained within the banking system but has shifted deposits toward those using rate more aggressively, especially in CDs, which have grown as other products have declined. Going forward, despite decreasing inflation easing consumer deposit runoff, Curinos projects that lagging effects will lead to continued runoff next year before a return to growth in 2025.
From a margin perspective, pressures on retail will mirror those on commercial. Nearly all banks will see rotation between lower-cost and higher-cost deposits as customers continue to remix from checking and low-rate savings to higher-yielding money market deposits (MMDA) and CDs. In addition, CDs acquired at lower rates earlier in the cycle will mature into a higher-rate environment, putting additional pressure on interest expense. In the last flat interest rate cycle, interest expense on consumer deposits increased by 15 basis points in the three months following the last Fed increase. With the Fed ending at a higher point and churn increasing in this cycle compared with the last, banks will need to plan for increased cost pressures throughout 2024.
In a market in which pressures begin to ease, retail deposits will afford opportunities for targeted growth or expense reduction. But relying on retail to fill the gap in balance sheets or P&Ls at this point will be much more challenging than it’s been in the past.