The FOMC held the Federal Funds target range flat at 5.25% to 5.5%. As previously communicated, the Fed has tapered quantitative tightening by $35B, lowering the redemption cap from $95 billion per month to $60 billion per month.
The real news, however, was in the Summary of Economic Projections (SEP). In the previous SEP, 10 of the 19 FOMC participants expected three or more 25 bp rate cuts in 2024. In the new SEP, the median FOMC participant now expects one 25 bp rate cut in 2024, with none expecting more than two 25 bp cuts.
Also worth noting is that the majority expect a rate between 4% and 4.5% at the end of 2025, which is meaningfully lower than today but still a level at which many of the tactical challenges banks face in managing funding costs would remain relevant.
Based on this revised outlook, the FOMC has publicly come around to what futures markets and market commentators have been saying for months: The most likely scenario is rates that are higher for longer. This remains the case even after factoring in the modestly better-than-expected June CPI print.
The scenario compounds challenges to bank profitability. Higher rates are driving bank funding costs up and commercial real estate valuations down, while mortgage origination volumes remain at a near standstill. Yield-curve inversion that gives ARMs no material advantage over fixed-rate products compounds the problem.
Many banks have baked three or more 2024 rate cuts into their plans, so now they’re scrambling to pare back interest expense. Even as top-of-market consumer acquisition interest rates have ticked down to about 5% nominal, portfolio costs keep rising.
It’s the same story in commercial, where customers continue to switch from non-interest-bearing (NIB) to interest-bearing (IB) products. In wealth, deposits are flowing back in, but at a cost as wealth customers increasingly demand exception pricing that’s directly competitive with money market mutual funds (Figure 1). And even in small business, where overall portfolio costs remain lowest, acquisition costs are creeping up toward those of commercial and wealth.
Figure 1: Wealth Savings/MMS Rates
The gap between published and actual rates paid on
wealth savings/MMS products has continued to grow.
To manage through higher-for-longer, banks need more than just cost-cutting plays. Along with tactical interest-rate management, such as consumer CD roll optimization, personalized marketing represents an enormous opportunity to catalyze the acquisition of high-quality customers. In wealth and commercial, relationship cross-sales and total-relationship pricing offer huge untapped potential. And higher rates mean more openings to offer financially meaningful advice to businesses and wealthy individuals on how to harness the time value of money through optimizing cash flows and working capital.
As we’ve seen over the past several year, the path of rates is unpredictable. But despite the latest modestly encouraging inflation numbers, banks should prepare for the challenges presented by higher-for-longer rates. Those that look both backward to leverage best practices from prior cycles and forward to harness the power of personalization and adapt to shifting buying preferences will be in the best position to thrive.
Retail | Home Lending | Commercial | Wealth
Retail Outlook
Demand for retail deposits remains strong despite slowing loan growth, while checking balances have stabilized. Deposits continue to flow to digital banks and into high-rate CDs, with some finding their way into high-rate liquid deposits at banks using savings promotions to manage duration.
Acquisition rates remain at around 5% even as portfolio rates continue to rise. Some banks are trying to lower rates and reprice back books to create capacity – both actions create opportunity for competitors, which is causing an uptick in churn. If Fed rate cuts don’t materialize until the end of 2024 or later, competition for high-rate deposits will persist, as will churn and portfolio-rate increases. For a bank with $50 billion in deposits, a 50 bp rise in portfolio rates means an additional $250 million in interest expense, assuming no changes to asset performance.
Winning lower-cost deposits through primary customer acquisition and relationship deepening is more important than ever. But the marketing cost to acquire new-to-bank retail customers has ballooned to ~$700, up 140% from pre-pandemic (Figure 2), which has made incentives a major lever for growing the customer base. There’s also more emphasis to more precisely manage the customer lifecycle, from prospect targeting to onboarding to deepening. The right improvements to onboarding alone have been shown to increase new-to-bank customers by 30%.
Figure 2: Average Cost Per Acquisition
Because of intensified competition, marketing spend has continued to increase, especially in deposits, making acquisitions more expensive.
Source: Curinos Marketing Analyzer, Kantar, Comperemedia, Curinos Analysis
Home Lending Update
Elevated market rates combined with meager inventory have produced an anemic spring buying season. May was up 11% from April but down 9% year over year (Figure 3). It’s a stark reminder that you can’t buy what’s not for sale.
Current conditions, however, have benefited existing homeowners. The Case-Shiller Home Price Index reached an all-time high in March, which has created momentum in the home equity market. In addition, the recent announcement that Freddie Mac (and presumably Fannie Mae) will enter the home-equity space is bringing newfound attention and liquidity.
As lenders look ahead to the prospect of lower rates in 2025, now is a good time for them to calibrate their product offerings. Options include affordable loan programs and those that target first-time homebuyers as demographics of new-household formation continue to shift to Millennials and Gen Z.
Adjustable-rate mortgages (ARMs) may also play a larger role in attracting new buyers and addressing affordability challenges. It’s true that year-to-date production remains unchanged from 2023 because of the persistently inverted yield curve, but ARMs still offer favorable rates relative to fixed-rate loans. That’s because the lack of liquidity in the secondary markets has made it difficult for banks and even non-banks to originate at attractive yields.
Figure 3: Retail-Funded Volume Change By Purpose, As Of May 2024
Purchase transactions grew month over month but were down year over year.
Still, demand is only one part of the economic equation. For the market to arrive at a healthy equilibrium, supply will have to meet it sufficiently, which will require offering incentives to both sellers and builders. And that, sorry to say, is hardly a short-term proposition.
Commercial Outlook
The greatest challenge to commercial profitability remains customer rotation from non-interest-bearing to interest-bearing deposits. When a customer moves funds from an earnings credit rate (ECR) account to an interest-bearing account, a bank will typically incur a net 300 bp or more in incremental interest expense.
In Q1 2024, we saw an incremental two-point reduction in the mix of NIB deposits to IB deposits. If this shift continues apace, NIB deposits will fall to roughly 25% of all commercial deposits by the end of the year (Figure 4). Given the yawning gap between typical ECRs (about 100 bp) and the top interest rates available on cash, both on and off bank balance sheets, the first few Fed cuts aren’t likely to alleviate the pressure.
Figure 4: Non-Interest-Bearing Commercial Deposits As % Of Total
NIB could shrink to just 25% of all commercial deposits by year end,
and the trend could continue even with falling rates.
For a $10B commercial deposit portfolio, this cycle-to-date remixing would result in a $75 million hit to net income. To manage through that headwind, banks will need to both invest heavily in total-relationship pricing and focus on monetizing investments in their payments and digital capabilities.
Banks have made enormous investments in bringing new payments rails to the market, developing tools to combat rampant fraud, integrating with an expanding ecosystem of technology providers and making onboarding and servicing faster and more intuitive. To fund these initiatives in the past, they were compensated through the promise of plentiful non-interest-bearing deposits. To the extent that those deposits don’t return, institutions and their customers will need to adapt to new economic models to support continued innovation.
Wealth Outlook
In stark contrast to 2023, wealth clients are bringing new-to-bank funds into wealth savings and money market savings (MMS) at nearly the same pace as the outflows from these same products. Because of strong acquisition and low attrition, wealth savings/MMS has grown 1.5% year to date, even after April tax outflows.
While few banks have increased their published rates on wealth savings/MMS, exception pricing is at an all-time high – 60% of total balances are exception-priced, with most banks hovering closer to 80%. Because of highly customized pricing, banks have a real opportunity to balance growth and margin by using elasticity modeling. It can help them better understand less elastic segments – those for which rates could be lowered without runoff risk – and pinpoint highly attractive clients for whom top-of-market exception pricing could sustain growth.
Another bright spot for wealth deposits is the persistent adoption of retail CDs. After initially appearing to be a short-lived trend, wealth clients continue to acquire short-term CDs, with more than 20% of acquisition balances going their way year to date. Retention rates for the first large buckets of maturities are significantly lower than retail, but CD-balance growth is nonetheless at 17% this year, and CDs now represent 11% of wealth-deposit portfolios. With each maturity, advisors have another opportunity to engage their clients and help ensure that those maturing balances are retained, as deposits or across the balance sheet in investments.
