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The Federal Open Market Committee (FOMC) voted to hold the target range for the Fed fund rate to 5.25%-5.50%, marking one year since its last hike in July 2023. It also lowered its projection for rate cuts in 2024 from last March from three rate cuts to just one. Based on recent economic data and statements from Fed officials, the most likely timing of the Fed's first cut in rates in this cycle will not be before the September meeting of the FOMC. Still, most bank treasurers subscribe to the theory that the most likely date for the Fed's first cut will be either in November, right after Election Night 2024, or if not by then, then by its last meeting in December. Meanwhile, the European Central Bank (ECB) voted to cut its benchmark rate by 25 basis points while suggesting that further cuts may take time and raising its forecast for inflation for the rest of the year as it struggles like the Fed and the Bank of England (BOE) to finish reining in post-Covid inflation.

Quantitative Tightening (QT) entered a new phase this month, as it continues under the Fed's new monthly cap for Treasurys, cut from $60 billion to $25 billion. At the same time, it decided to keep the Agency Mortgage-Backed Securities (MBS) cap at $35 billion and reinvest run-off over that cap in Treasurys. This month's balance in the Fed's System Open Market Account (SOMA) portfolio stood at $6.80 trillion, of which Treasurys equaled $4.45 trillion and Agency MBS equaled $2.35 trillion. Since June 2022, when QT began, its Treasury portfolio has been shrinking at a pace of $54 billion a month, and its Agency MBS portfolio has been shrinking at $17 billion a month.

The yield curve remained inverted this month for the 20th month in a row, the longest it has ever been inverted measured by the spread between the yield on 5-year and 3-month Treasurys going back to 1981 and is flat beyond the 5-year term out to 30 years. Yet, even with the inversion of the yield curve, mortgage rates, which generally price off the intermediate part of the yield curve, are historically high for this century. Borrowers are consequently paying 7% or more to finance a home purchase, a cost compounded by record-high home prices because of limited supply as existing homeowners stay put. While bank treasurers are generally comfortable about the Fed holding interest rates higher for longer, they continue to list the inverted yield curve as one of their critical challenges for generating net interest income (NII). Nevertheless, holding $3.4 trillion in reserve deposits at the Fed, the banking industry has been generating 16% of its interest income in the last year, thanks to the Fed's 5.4% Interest on Reserve Balances (IORB).

The latest call report data for all commercial banks shows the cost of interest-bearing deposits climbing, averaging 2.5% in Q1 2024. Nevertheless, the universal message from bank executives this month continues to be that deposit repricing beta is stabilizing and that they are seeing stabilizing trends in the shift in mix from noninterest-bearing deposits to interest-bearing. They are also reporting that they have been shortening the term of their Certificates of Deposit (CDs) from a year down to 3 months in anticipation of rolling these deposits before the end of the year at a lower rate, assuming the Fed cuts before the end of the year. Even though the yield give-up to extend from 3-months to a year is no more than 25 basis points, retail customers, according to bank treasurers, are still only interested in getting the highest rate and not trying to weigh economic trade-offs between earning the highest rate possible today and protecting future interest income when the Fed cuts.

Loan demand remains flat, which bank treasurers believe may have contributed to taking some of the pressure off deposit prices. When and if the Fed cuts rates this year, they expect it will help spur loan demand, which could increase deposit competition and renew upward pressure on deposit pricing, offsetting relief from rate cuts. Tighter bank regulation around possible new liquidity requirements in the wake of the bank failures last year may also factor into deposit pricing. Thus, bank treasurers generally do not see the competitive landscape for deposit funding as intense as last year, but they also do not see much room to cut deposit rates even when the Fed begins to cut.

The Bank Treasury Newsletter June 2024

Dear Bank Treasury Subscribers,

June is an excellent time to get away from the office and go pond fishing. Everyone in the bank treasury world seems to take vacation around this time, so feel free to disconnect and step back because even bank treasurers who work all the time occasionally need a vacation. Besides, the Fed just told us that rate cuts are on hold until after the summer, if not until next year, which means that the fixed-income markets will still be in a range-bound holding pattern waiting for you when you return.

Pond fishing is a very peaceful summer pastime. After all, once you dunk hook, line, and sinker in the water, there is nothing to do but sit around and wait for the fish to bite. So, prepare to wait a long time because the fish are not stupid, and they know how to deal with baited hooks, which gives bank treasurers plenty of time to think about the big picture they see as they head into H2 2024. And their picture is very big and complicated, so they will need the time to sort it through, at least a whole newsletter’s worth.

Big pictures are like the forest and the trees. The forest can get lost in the trees, but without the trees, you cannot see the forest. Details matter, but they are easy to get confused. The economic landscape is an excellent example of how making sense of the forest or the trees can be challenging. Thus, while the data-dependent voting members of the FOMC are predisposed to ease monetary policy, and all they need is for the economy to give them a good reason to do so, that reason has proved elusive. There is no shortage of economic pundits in and out of the Fed who believe that the good reason is staring them right in the face that the economy is already flashing warning signs. Still, unfortunately, as usual, given their backward-facing position, the FOMC will only see the missed signals in hindsight. But there is also the argument that this time is different.

Economic Picture is Still Cloudy with a Chance of Rain

Thus, the big picture might be that inflation is slowing this year, with the Fed’s preferred gauge, the Consumer Purchase Expenditures (PCE) index, down to 2.7% in April 2024. The PCE index was 5.0% in September 2022, so the latest April 2024 reading is an improvement. But hold on! The index is higher now than in January and February 2024, when it equaled 2.5%, and higher than in December 2023, at 2.6%. Moreover, excluding food and energy, the PCE index stands at 2.9%, and decimal places aside, 2.5%, 2.6%, 2.7%, and 2.9% still do not round down to 2%, the Fed’s long-run target for this inflation statistic.

The other part of the economic picture is that while inflation is improving, albeit slowly and unevenly, the economy remains surprisingly robust. Nonfarm payrolls (NFP) in May 2024 climbed by 272,000 full-time jobs. The first-rate hike by the Fed was in March 2022, and since then, the Fed’s restrictive monetary policy aside, NFPs have averaged 298,000 a month. To put this number into perspective, from December 2015 to December 2018, during the previous rate hiking cycle, the average monthly NFP was 189,000.

Since July 2023, after the Fed’s last rate hike in this cycle, monthly NFPs averaged 208,000. Job creation during this rate hiking cycle, based on nominal numbers, is the strongest in decades. Inflation and NFP statistics do not tell the whole story about the economy, which may still be defying gravity or finally succumbing to the pressure of the Fed’s restrictive monetary policy, depending on the latest retail sales, industrial production, housing construction, confidence survey, or GDP number that comes out next.

No Cuts in the Big Picture

With no consistent trend in the data that matters, the big picture is the bottom line, which is that there are no rate cuts in the picture, no matter how expansive the horizon is. Oh sure, someday, one day, probably by year-end, but that is no longer certain, the Fed will cut. The chairman, president, and chief executive officer (CEO) of a large regional bank in the southeast, speaking before the FOMC’s release, told analysts this month that he was bearish on any cuts this year,

“I think that if we get one cut this year, I'll be surprised. and there's a good chance we don't get any cuts this year given this overall stickiness that we're seeing with inflation. Two days from now, we'll know more. “

Because the picture is unclear, and the FOMC needs a clear picture showing progress on inflation getting back to its long-term 2% target, as he continued to explain,

“I think they've been very direct about it. They need to see sustainable progress that we're approaching that 2% target. And I don't know whether you measure that in months or quarters. They seem to be talking about months at this time, but I think you've got to see that over the next two or three or four months. And then I think you'll see the Fed start to cut rates.”

But why should the Fed cut rates? Who wants that? This question is of particular interest to bank treasurers with a big pile of cash earning overnight interest on reserve deposits at the Fed at 5.4%, a risk-free overnight rate that also happens to be the highest point on the yield curve.

5.4% Risk-Free!

Getting paid 5.4% overnight and risk-free is not too bad in the big-picture scheme of things, considering all the interest rate, credit, and liquidity risks bank treasurers usually need to take to generate interest income. According to the Fed’s H.4 report, commercial banks held $3.4 trillion in reserve deposits at the Fed, 15% of their total assets, which means that over the last year, using the proverbial back-of-the-envelope, bank treasurers have earned interest income totaling $190 billion courtesy of the Fed.

Risk-free overnight interest income of that size is a gift. To put this number into context, the FDIC reported last month that the banking industry earned $1.2 trillion of interest income in the previous four fiscal quarters, from Q2 2023 to Q1 2024, so 16% was generated risk-free courtesy of the Fed’s monetary policy. Even better, the Fed’s main message to the markets, at least as far as bank treasurers sitting on cash are concerned, is to let the good times roll. So, why complain?

The CFO of a large regional bank on the East Coast was not just sitting on a lot of cash at the Fed. His earning assets, including his bond and loan portfolio, were concentrated in the front end of the yield curve, which is excellent, provided rates stay at these levels long enough to reprice his assets before the Fed ultimately cuts. As he told analysts,

“We’re -- among our peers, our duration, no reveal here, is shorter. We're at the front of the line in terms of being able to reprice. Everyone will be able to reprice their fixed rate assets. But if they're not maturing, you got to wait for that to happen.”

By The Invisible Light of R-Star

Charting the economic terrain before them, the voting members of the FOMC steer their course led by an unobservable R-Star, a hypothetical neutral overnight interest rate where the economy is at full employment and price inflation is stable. With R-Star to guide them, they still believe that their present monetary policy is economically restrictive enough even though, to date, a 5.25%-5.50% target range for the Fed funds rate and its program of balance sheet reduction through QT has failed to contain inflation, much less have cooled off employment.

Even if their current policy is restrictive, how restrictive is unclear, as models differ. Perhaps it is not restrictive enough? But for now, they are not asking that question. When asked whether the FOMC could vote for another hike, Chairman Powell said he was confident that the Fed funds rate did not need to go higher. At least, not in his base case. As he told the press this month when asked about the possibility of another rate hike,

"Not to eliminate the possibility of hikes, but, you know, no one has that as their base case. No one on the committee does."

Even if its next move was to hike, it is unlikely that it would be a sudden decision, judging how the Fed was so slow to move against inflation in 2021, which may have led to the rate environment we are in today. If it had moved sooner to raise rates, the argument goes, the Fed may not have needed to go as high and as fast as it did. But even hindsight has its limits on shedding light on the past, and we might have still ended up with an effective Fed funds rate holding above 5.3%.

Regardless, most bank treasurers believe without question that FOMC officials would give them plenty of warning if they were about to reverse course and seriously consider the possibility of raising rates at this point. Voters would be giving speeches and putting out plenty of forward guidance before they would raise rates. As the above-quoted chairman, president, and CEO of a large regional bank in the southeast said, the Fed would not surprise the market with a sudden hike in rates. Not now.

“I would say it's not off the table in my view, but I think it's rather unlikely that the next move is an increase. I think you will have a whole lot of forecasting and verbal communication before that becomes a real possibility…We'll get a new dot plot this week, which in some ways is useful. But it also answers just one or two of the questions not all of them. I'm in the camp that you wouldn't get a rate increase without a whole lot more clarity from the Fed.”

So, no bank treasurer is seriously worried about a sudden drop in rates, although losing all that risk-free interest income, going back to a normal yield curve where they must use judgment about term structure, decide where the best place on the curve would be to price assets and deposits and work a little harder to generate NII will hurt a little bit. But how big a deal is lower rates for banks? Rising rates have caused bank failures, but banks do not generally fail when rates are falling. At least not suddenly, as three of them did last year because the Fed raised rates.

High rates have not dented employment yet, but the Fed’s monetary policy has been plenty restrictive on the housing industry, where first-time home buyers can barely afford a mortgage, let alone find a house to buy with it. Existing homeowners, especially those who signed their mortgage contracts before 2022 when mortgage rates had 2-handles on them instead of 7-handles, are staying put in their homes and holding off at downsizing. This is reducing the supply of homes and helping to push home values to new heights, at least on paper.

And so, despite a robust employment picture, according to a government website, there is a homeless crisis in this country that is getting worse. Between 40%-60% of the people without a home may have a job but cannot afford shelter, much less food, because the cost of housing has grown faster than their wages.

A Matter of Political Perspective and Credibility

This is where politicians enter the picture, clouding what should be a purely independent decision by the FOMC about setting a benchmark interest rate based on what is best for the long-term optimal health of the economy. There is the upcoming Presidential election to consider, and many bank treasurers subscribe to the theory that the Fed would not cut or hike the Fed funds rate right before an election, although notably, the next to last FOMC meeting of the year begins on November 6th, a day after the national election.

The Fed does not want to appear by its actions to favor any political party as a matter of policy. But even doing nothing is doing something, at least in the political big picture of which the Fed is a part. The Fed’s policy is about more than economics. It is a campaign slogan, as this letter from Senators Elizabeth Warren, John Hickenlooper, Sheldon Whitehouse, and Jackie Rosen attests. Dear Chair Powell, they wrote,

“We write today to urge the Federal Reserve (the Fed) to cut the federal funds rate from its current, two-decade-high of 5.5%. This sustained period of high interest rates is already slowing the economy and is failing to address the remaining key drivers of inflation. Furthermore, the European Central Bank (ECB), which like the Fed has a mandate to steer inflation towards a target of 2%, cut interest rates for the first time in five years. It’s time for the Fed to do the same.”

Of course, the Senators undoubtedly know that there are different central banks for a reason, and what works in one country may not be appropriate in another country. The fact is that inflation is falling faster in the European Union than in the U.S., even if the progress on that front seems as if it has stalled out this year. Also, arguing that the largest and most important central bank in the world should take its cue from another central bank sounds almost insulting. But leaving these quibbles aside, when the ECB cut its benchmark rate by 25 basis points this month, it also raised its forecast for inflation in 2024, justifying its rate cut based on its forecast that inflation would get back in line with the bank’s 2% goal by next year.

However, if a central bank has any power over the financial markets, its decisions must be credible and consistent. If you say, as the Fed has said, that it will remain skeptical that inflation is getting back to its 2% long-term goal and biased in favor of holding rates at a restrictive level until there is evidence persuading you otherwise, you cannot suddenly turn around and cut rates when the inflation numbers round up to 3%, much less cut them when you expect inflation at least in the short-term to still increase. Not without losing credibility, and it is not clear that the ECB’s decision was anything other than a political statement if for no other reason than both the Fed and the BOE this month held fast to their restrictive policies.

Whether the Fed’s monetary policy is effective enough is an open question. FOMC officials generally speak of a lag effect, though without defining a timeline, when lag is no longer an excuse for ineffectiveness. But the Senators make an interesting observation that mortgage rates and auto insurance premiums are contributing to inflation, the former which, if it were lower, would help reduce inflation, and the latter, which is not directly connected to economic imbalances between supply and demand and thus not determined by interest rate levels.

Lowering interest rates to reduce inflation almost sounds counter-intuitive, as they conceded in their letter since the point of higher rates is to curb credit creation by banks to slow an over-heating economy of which high inflation is supposed to be a symptom. If higher rates do dampen home buying or reduce auto purchases because debtors cannot afford the interest payments, that is a cost of monetary policy to control prices.

Notwithstanding the merits of their complaint to Chair Powell, there is the awkward but inescapable fact that the only interest rate the Fed can directly control is the overnight rate, not the 10-year Treasury rate and not mortgage rates, to which they are tied. Mortgage rates are the highest they have been in more than two decades, but so is the yield on the 10-year Treasury. Even at 4.2%, which is 120 basis points below the overnight rate that the Fed pays banks for their reserve deposits, the rate of the 10-year Treasury is still higher than it was more than 20 years ago. Thus, if the Senators really wanted to help first-time home buyers afford a mortgage, they should write a letter to whoever controls forward rates to get them to make the yield curve even more inverted than it already is.

SOMA’s Impact

And since the rate in question that the Senators want to cut are mortgage rates and not the overnight rate, there is little the Fed can do to bring down the former other than, say, to ramp up its investment in Agency MBS in its SOMA portfolio. Perhaps the Fed could help bring down mortgage rates by buying a massive amount of Agency MBS at this point; for the past two years, the Fed has been trying to shrink, not grow, its investment in the asset class.

Thanks to the fact that the Fed bought most of this portfolio when rates had 2-handles and not 7-handles of them, after two years of QT, most of what it purchased during QE is still on its balance sheet. While it is not trying to sell its $2.4 trillion portfolio of Agency MBS outright, which likely could push mortgage rates higher, the Fed began this month to take the principal cashflows from the portfolio and reinvest them in Treasurys. The bottom line is that the Fed is not trying to support the residential mortgage market, however much the Senators wish it would do.

This is not to gainsay the size of the SOMA portfolio, which at $6.8 trillion, including $4.5 trillion of Treasurys and $2.4 trillion of Agency MBS, eclipses the banking industry’s aggregate investment portfolio, which the latest H.8 data put at $4.2 trillion, including $2.5 trillion in Agency MBS and $1.6 trillion in Treasurys. And SOMA is large relative to outstandings. According to the U.S. Treasury, there are $27 trillion of marketable Treasurys outstanding, of which $6 trillion were originally issued as T-Bills, $5 trillion were originally issued as 20 years and 30-year T-Bonds, and the rest were issued as T-Notes ranging in maturity from 2 to 10 years.

However, QT on paper does not seem like it should have much of an impact on the Treasury or Agency MBS markets in terms of trading volumes or new issuance. Trading volume in Treasury coupons averaged $616 billion a month over the last twelve months, which compares to the Treasurys the Fed holds in its SOMA portfolio, which have been running off at an average rate of $54 billion per month. Treasury net issuance in 2023 equaled $3 trillion, of which Treasury coupons accounted for $0.4 trillion.

QT should have even less of an impact on trading markets with the Fed’s new $25 billion QT cap on Treasurys in place starting this month. The Treasury’s monthly average net issuance, excluding T-Bills, was $59 billion. Including T-Bills, which mostly went to feed the money market funds, who are using them to replace their investment in the Fed’s RRP, and which also went to meet additional demand by private investors on Treasurydirect.gov, average monthly net issuance over the last year was $207 billion.

According to a recent study, a third of the Treasury securities outstanding come due within a year, given the high proportion of T-Bills that are outstanding in the Treasury. However, the run-off of T-Bills from the Fed’s $0.2 trillion investment it holds in SOMA, a level which is probably going to remain stable when the Fed ultimately ends QT, hardly seems like it should be much of a factor on the pricing of T-Bills.

Similarly, the Fed’s investment in Agency MBS requires some putting in context. At year-end 2021, according to the latest available estimate by SIFMA, Agency MBS outstanding equaled over $9 trillion, a figure that most likely increased even if mortgage loan origination volume is down by two-thirds from the peak in 2020 and not much better this year. In the last twelve months, SIFMA reports that the average monthly issuance in Agency MBS, including CMOs, has been $111 billion, while trading volumes have averaged $271 billion. Meanwhile, monthly principal cash flow from the Fed’s Agency MBS portfolio averaged $17 billion over the last year.

Shrinking Reserve Deposits After RRP

Theoretically, the purpose of QT is to shrink the supply of liquidity in the financial markets, thus tightening trading conditions and raising the overall level of interest rates. Before the global financial crisis, the Fed used to regulate the supply of reserves, keeping them tight enough to control the effective Fed funds rate (EFFR). But of course, after December 2008, the Fed changed the rules and not only flooded the financial system with excess reserves, but time and again has reaffirmed its commitment to maintain a level of reserves far beyond what banks require to manage payments, to hold as a source of liquidity, or for to earn risk-free interest income.

With the balance of reserves at $3.4 trillion, more than twice as much as existed in the system in March 2020, regardless of how the Fed describes the level of reserves as “ample” or “abundant,” it still has no direct way of determining an overnight rate by regulating reserve balances. Instead, it controls the EFFR with the IORB and the RRP. The IORB is set at 5.40%, which is 10 basis points below the top of the target range for EFFR, and the RRP rate, which is set at 5.30%, which is 5 basis points above the bottom of the range. With these two rates providing a ceiling and a floor, the EFFR has held steady at 5.33% since the Fed’s last rate hike in July 2023.

But with the balance of the RRP now under $0.4 trillion, bank treasurers are thinking a lot about what happens now with QT and whether reserves, which have basically stayed flat even while the Fed shaved off $1.7 trillion from its balance sheet, will start to shrink. The good news, if they are worrying about it, is that the Fed is tapering QT, and presumably, soon, it will stop shrinking its balance sheet altogether and still leave the financial system swimming in more liquidity than it was four years ago.

But it is understandable why they may be worried. Bank deposits remained relatively stable thanks to the fact that over the last two years, the Fed has used the RRP and not reserves to balance the run-off from SOMA. Connected or not, according to the H.8 data, since June 2022, commercial bank deposits fell by a grand total of only $364 billion, down 2% from $17.9 trillion. The CFO of a large regional bank in the northeast told analysts,

“The RRP has been a shock absorber for QT for several quarters. And we suspect that the RRP in the coming quarters will not be as much of a shock absorber as it's been. If the Fed keeps its foot on the pedal with QT, it may have an impact on deposit levels across the system.”

The CFO of a large regional bank in the Midwest was worried because if what the above-quoted CFO said happens and the Fed does not stop QT soon, even with a Treasury cap cut from $60 billion a month to $30 billion, reserve balances may fall too far and leave the market vulnerable to another disruption, as happened in the repo market in September 2019,

“The RRP is one that we've been paying a lot of attention to. We think they're at their floor right now and we're not expecting them to go to zero…It's very clear when you look at the Fed balance sheet data, when you look at reserves, that the RRP has absorbed a lot of the reduction in market liquidity. So that is something that we're cautious about if for some reason, we see…funding pressures out of bank deposits or challenges…where some folks might start getting short on reserves.”

The RRP saved banks from seeing more deposit outflows last year than they had expected, explained the CFO of a global bank,

“Last year, we thought our deposit levels would go down 8% to 10%...given the regional bank crisis, the geopolitics and the debt ceiling. But we were a little better to the upside. We expected to grind lower this year as well…But in Q1, we didn't really see that happen…it came out of the RRP.”

Inverted Existential Peril

The yield curve is another part of the picture bank treasurers struggle to understand, and as Alan Greenspan noted, the longer end of the yield curve can be a conundrum. However, Chairman Greenspan never saw this picture of a yield curve as it exists today, where the negative spread between the 3-month and 5-year Treasurys has averaged more than 100 points since October 2022. However, the spread has also been volatile, swinging back and forth by 30 to 40 basis points depending on the market’s views on the prospect for rate cuts, trading as data dependent as the Fed.

Interest rate scenarios, such as those published by the OCC semiannually since October 2020, focus on parallel shocks, where the front, long-end, and the belly of the yield curve all move up or down simultaneously. But interest rates can move in more complicated directions. The yield curve could bull flatten, where the back end falls faster than the front end when the Fed cuts rates because the market anticipates even further cuts by the Fed on the front end. Yield curve shape projection is hard to predict, but the ideal interest rate scenario, as far as bank treasurers are concerned, is where the front end of the yield curve falls, and the long end stays anchored, also known as a bull “steepener.”

This scenario will return the yield curve to a standard shape where depositors earn higher interest rates for longer than shorter terms, the opposite of what prevails today in deposit pricing. Higher for longer would be fine for bank NII and Net Interest Margin (NIM), provided the yield curve returned to a typical, positive slope. The CFO of a large asset-sensitive regional bank in the Midwest told analysts that higher for longer where the yield curve remains inverted is good and bad for bank treasury,

“The range of interest rates that drives our business is the three months to the five year. The real belly of the curve. And what we're seeing is a higher for longer scenario. There are positives and some challenges. The biggest positives with respect to our NIM at this point is the fixed asset repricing…Relative to the yields on the loans that are paying down versus the newly originated loans in that category we're seeing between 250 and 300 basis points yield improvement…The challenge is the inverted yield curve. I've seen some statistics recently that depending on which yield curve metrics you look at this is either 40 years or 60 years since we've seen the yield curve as inverted as this.”

The CFO of a large regional bank based on the east coast, agreed,

“For us, an ideal would be a steep yield curve. Less ideal is an inverted or more inverted yield curve.”

Bank treasurers need to think strategically because while the Fed may be saying it is probably not cutting rates this summer and possibly not all year, eventually, it will be cutting the rates it pays on IORB and RRP. When it does, with any luck, the front end of the yield curve will fall, and the back end will stay anchored or not fall by as much. The question is how to prepare for that eventuality because the inverted yield curve complicates the cost equation for hedging against lower rates.

For one thing, you earn less nominal interest on a swap's receive-fixed leg than your counterparty, receiving a floating rate. That can turn into a lot of interest given up to lock in yields on earning assets, especially if higher yields for longer are higher rates and an inverted yield curve forever and well into 2025. The CFO of a large regional bank explained how his bank was adjusting its hedging strategy using interest rate swaps to prepare for eventual rate cuts and potentially some flattening in the yield curve.

“Generally speaking, we're modestly asset sensitive. We've kept that position intentionally to capture the benefit of the higher for longer rate environment and that's worked quite well...As we go forward, we intend to gradually reduce our asset sensitivity…And that's already baked into the hedging and swap plan gradually increasing received fixed swaps on a forward starting basis in the early to middle part of next year and gradually allowing expiration of our pay-fixed swaps in a similar timeframe.”

Deposit Strategies as the Fed Stays on Hold

As bank treasurers tell this newsletter, retail depositors do not pay much attention to forecasts on interest rate cuts. They are only interested in the highest rate they can earn, even if extending from a 3-month to a 12-month CD would cost them only a quarter-point of yield give-up. But as far as the CFO of a large regional bank in the northeast was concerned, if the customer does not care and wants to stay short, even if that means paying the customer a higher interest rate, it will all work out in the end for bank treasurers, assuming the yield curve reverts to a positive slope.

“We have progressively moved our CD book to shorter duration…We're five or six months in duration….is costing us a little bit more than if we were longer right now, but we're taking a long-term view. We think eventually we'll have an upward sloping curve that will benefit from that at some point down the road.”

Bank treasurers are shortening up their CD offers, according to the CFO of a large regional bank in the southeast,

“This time last year, we were offering 11-month CD rates, now we are looking at a much shorter term and a lower rate. The difference in rate between CD and money markets is getting much closer here…The closer we all get to that first rate cut, the duration's coming down on those rate offers.”

They have a lot of thinking to do about deposits and pricing in the coming months, even if the Fed stays on hold for the rest of the year or even if the Fed cuts. One school of thought, for example, says that rate cuts could spur competitors to hike rates to grab market share. The CFO of a large regional bank in the Midwest explained how deposit rates could go up when the Fed cuts,

“Most of us would think deposit are there to fund…loans. So, if there's no loan growth, there's probably less pressure on deposit rates. So, it might feel counterintuitive that rates stay higher. But if we see a cut or two loan demand picks up, so, then you might not see betas move as quickly because we'll want to maintain the deposit funding.”

Balance sheet structure should play a role in deposit costs, as banks with an above-average ratio of loans to deposits theoretically tend to pay more for their interest-bearing deposits than banks with low loan-to-deposit ratios (LDRs). However, call report data does not support this theory so well. For example, in Massachusetts, where the average LDR in the state was 95% in Q1 2024, the average cost of interest-bearing deposits in the quarter was 2.5%. In Texas, the average LDR was 68%, and the cost of interest-bearing deposits was 2.6%. Broadly, based on a simple national average (Figure 1), interest-bearing deposit costs are still climbing and not showing any sign of flattening out in line with the message to equity markets.

**Figure 1: Cost of Interest-Bearing Deposits: All Commercial Banks**

Trying to get a big-picture perspective on deposit pricing is not easy. According to the CFO of a regional bank in the Midwest, deposit pricing decisions depend on the market, the product, and the size of the bank,

“The main difference really is between the larger banks, the midsize banks, and then small banks, large credit unions. So, the large banks in general, we've seen them maintain a significant amount of discipline, especially in the consumer books. We've just not seen a lot of rate competition from them. In the markets where…larger banks get a little more aggressive…in wealth…as well as the commercial portfolio…we will see…more aggressive offers when they're…basically trying to buy a relationship.”

You can make generalized comments like this about large banks, but smaller, mid-sized institutions are a little different. As he continued,

“Midsized banks, it tends to be more company specific. We are seeing folks that continue to have…work from a funding perspective, who are tending to be a little bit more aggressive. And those that are focused on just outright growth. They're tending to be a little bit more aggressive, but it really is an institution by institution and market by market basis. “

But if you are looking for a signal that deposit pressures have stabilized, look no further than what has been going on with the smaller community banks, as he concluded,

“Probably the more interesting one recently has been -- we've seen a bit of a pullback from smaller banks and credit unions. Last year they were competitive, especially in the CD offers, and that's a spot where we've seen them come off a bit. But overall, broadly speaking, we continue to feel a decrease in competition relative to where we were late last year and the trends have been stable for the past five, six months…The demand deposit account (DDA) migration has also decelerated. The last three months of DDA migration have been the lowest that we've seen since the hiking cycle began.”

The CFO of a large regional bank based on the east coast offered to sum up the entire deposit situation with one word,

“Deposits, the message is stable. Our noninterest-bearing deposit balances are higher than they were at quarter end…This is the first time I've seen them go up like this…That tells me that at a minimum, things have stabilized considerably.”

Deposits are stable, said the CFO of a large regional bank in the Midwest, which means that on the one hand, bank treasurers do not have to worry anymore about the risk of a deposit war, but also that there is not much opportunity to reduce rates yet,

“I think maybe the best way to describe it is stable…I would say we feel like there's less room for taking rates down...There's going to be ongoing competition around deposits. I don't think rates are spiking, but I don't think it's decreasing as much as people would have expected.”

But the effect of rate cuts on deposits is not the whole story. Even if pressure is easing for them on the right side of their balance sheet, the prospect of rate cuts could spur loan growth, which could intensify pressure on deposits, as the CFO of a large regional bank in the explained,

“We've seen the deposit cost environment top out, and we are seeing now the beginning stages of down beta management in the environment broadly…We're seeing shortening of CD deposit offers, testing of lower price points in various customer segments and geographies. So that's occurring. And yet also, we're seeing loan growth across the industry stabilized and I think it's poised to continue to modestly grow over the course of the remainder of this year, which is increasing the demand for deposit gathering across the sector, which is somewhat increasing competition.”

Borrowers Cannot Hold Their Breath Forever

The loan picture still seems weak according to H.8 data, which shows growth has been flat all year, growing by just 1% in the last twelve months. But borrowers may need to step up, as bank treasurers theorize that they must be running out of their Covid stimulus cash and might be on the verge of capitulating and finally drawing down on their untapped credit lines. The CFO of a northeast regional bank expected capitulation and that the loans were coming; it is just a matter of time,

“They've been strengthening balance sheets ever since the pandemic, they've been managing their costs. The other input is that rates are still high. Inflation is still there…I think that as time passes, I think there will be some capitulation.”

At a large regional bank in the Midwest, the CFO also believed that borrowers are on the verge of capitulating,

“I think there's a big psychological effect from interest rates…the expectation is that rates are going to come down and so people are willing to hold their breath. Now there is a limit on how long that people can do that we would expect to see some capitulation at some point where people have just put off investment decisions for a long-time. Because you're seeing the economy continue to perform better than people were expecting…and at some point, that is going to force an investment decision even if rates stay higher.”

Regulatory Uncertainty

But the lending picture is not simply a question of supply and demand. The motivating slogan for bank management these days is risk-weighted asset (RWA) optimization, which means, in practice, that the bank’s balance sheet must earn a return on top of its cost of capital. In anticipation of higher capital requirements, large banks are reappraising the value of their banking relationships by this metric and adjusting to reduce their investment in the assets that do not meet it. If this is the price of sound banking, so be it. However, from a public policy perspective, when the banking industry can no longer provide all the necessary credit to the market because many businesses do not generate enough return on capital to justify the investment, the public needs to think carefully about unintended consequences.

There is nothing wrong with bank supervisors requiring the banking industry to hold more equity capital if holding more equity capital would prevent the next banking crisis. However, there is no clear, straightforward answer as to why Silicon Valley Bank (SVB), Signature Bank, and Republic Bank failed last year or any obvious way for bank supervisors to explain to the public why the Basel 3 Endgame capital requirements will be the solution and not just another iteration of capital regulations that lead to Basel 4, 5, and 6.

These are good public policy debates, but they sit inside a political dimension, where, like the Fed’s monetary policy, bank supervision is another campaign slogan. For Senator Elizabeth Warren of Massachusetts, Chair Powell’s willingness to engage in these debates is part of the problem. As she wrote to him this month, Dear Chair Powell,

“Big U.S. bank CEOs met with you more than a dozen times between last July and March, according to the central banker’s public calendar…This is a highly disturbing turn of events. Your opposition to the Basel III rules is not new. But it now appears that you are directly doing the bank industry’s bidding, rewarding them for their extensive personal lobbying of you. Taking orders from the industry that caused the 2008 economic meltdown would sacrifice the financial security of middle-class and working families to line the pockets of wealthy investors and CEOs, and further undermine public faith in the integrity of the Fed—a faith that has already declined considerably due to a series of scandals and failures under your watch.”

The Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018, better known as the Crapo Act, rolled back some of the capital and liquidity requirements required under the Dodd-Frank Act. Thus, the argument went, SVB was not subject to the Fed’s stress test in 2023, which presumably might have revealed that it was a financial crisis disaster waiting to happen. It should not have been exempt from capitalizing its negative Accumulated Other Comprehensive Income (AOCI) in its regulatory capital, which might have prevented it from taking a loss in its security portfolio. At least, that is the argument.

But bank treasurers know full well that all the equity capital in the world that SVB could have gathered would not have prevented the deposit run it suffered, that the stress tests the Fed administers every year would have passed a bank such as SVB with flying colors, and that there is a lot of reason to tailor capital requirements based on a bank’s systemic footprint. The problem with systemic footprints is that it is not always easy for regulators to anticipate the sequence of events that would transpire to turn SVB’s attempt to restructure the securities in its available-for-sale portfolio into a general call for depositors to run. SVB’s tangible common equity ratio, including AOCI, was nearly 6% when it failed, which is hardly the capital profile of a bank with insufficient capital.

But that is not the nuanced picture that Senator Warren painted in her letter,

“The Trump era regulatory rollbacks that you shepherded watered down the Volcker Rule, which allowed SVB to load up on risky investments, setting off its collapse and the domino effect that spread to Signature and First Republic.”

Bank treasurers might tell the Senator that while the new capital rules that they expect to come out of the Basel 3 Endgame, whenever that happens, will be manageable, the liquidity rules that bank supervisors are contemplating may be a little tougher to manage and could change some of the pricing dynamics around retail deposits. The CFO of a large regional bank in the Midwest connected his bank’s build-up of reserve deposits to expectations around liquidity requirements and the Fed’s balance sheet plans,

“Part of it is an expectation that the rules are going to get a little bit tougher…there's going to be a focus on higher runoffs on uninsured deposits. And so that is an area where we just want to make sure that we are incredibly well positioned because we do worry about when those rules come out. Could that be a catalyst for a scramble for liquidity or an increase in deposit competition? We just want to make sure that we stay very well-positioned on that front. And especially when you layer that on with some of the market mechanics that we talked about earlier with RRP and QT. That's part of why we're staying with a lot of liquidity, it just gives us a lot of flexibility.”

At some point, when the Fed does finally cut interest rates, the best of times for bank treasurers who have been sitting on a big pile of cash on which they are earning more than 300 basis points of spread will come to an end. For now, however, the Fed is still paying bank treasurers to sit back and do nothing, precisely what pond fishing is all about. Enjoy the vacation while it lasts.

The Bank Treasury Newsletter is an independent publication that welcomes comments, suggestions, and constructive criticisms from our readers in lieu of payment. Please refer this letter to members of your staff or your peers who would benefit from receiving it, and if you haven’t yet, subscribe here.

Ethan M. Heisler, CFA

Editor-in-Chief

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This Month’s Chart Deck

Bank treasurers are still sitting with large cash piles on deposit at the Fed (Slide 2), earning 5.4% Interest on Reserve Balances (IORB), which contributes about 16% (Slide 3) of the industry’s total interest income. Aside from the risk-free return offered by IORB, demand for liquid assets increased and remained elevated after the regional bank crisis in March 2023. Banks reduced the average life of their earning assets over the last two years and generally maintained more asset-sensitive balance sheets (Slide 4).

While depositors continued this year to shift their noninterest-bearing deposits into interest-bearing CDs, the Office of the Comptroller of the Currency’s (OCC’s) latest semiannual interest rate risk survey of the national banks found that the industry was lengthening its estimate of the average life of non-maturity deposits, including Negotiable Order Withdrawal (NOW) accounts and Money Market Deposit Accounts (MMDAs), with NOW accounts estimated in the current survey at 4.7 years and MMDAs at 3.7 years. The median estimate for noninterest-bearing deposits held steady at 5.0 years (Slide 5).

The relationship between a bank’s loan-to-deposit (LDR) ratio and its cost of interest-bearing (IB) deposits is not apparent from the data in Slide 8. The average bank chartered in New Jersey, where the average LDR equaled 98%, and at the other end of the scale, South Dakota, where the average LDR equaled 60%, reported the cost of IB deposits in Q1 2024 equal to 2.6%.

Over the last decade, the U.S. Treasury increased its debt outstanding in Bills, Notes, and Bonds from $11 trillion at the end of 2013 to $24 trillion as of last month. But it also changed the mix, with T-Bills growing from 15% to 24% of total outstanding (Slide 7) as it ramped up its net issuance from less than 10% of total net issuance in 2021 to 30% of net issuance through the first five months of 2024 (Slide 8). While money market funds used the T-Bill issuance to replace their investment in the Reverse Repo Facility, which fell by $2 trillion since the Fed began Quantitative Tightening (QT), to $0.4 trillion, individual investors also increased their investment in the asset class, holding a $441 billion in December 2021 and going to $2.4 trillion at the end of last month (Slide 11).

This month, the 10-year Treasury yield rallied more than 40 basis points, falling below 4.3%. However, mortgages remain cheap on a spread basis to the 10-year Treasury.

The Fed remains the largest central bank in the world, even after two years of QT. Based on total assets, the European Central Bank, whose member national central banks include France, Germany, Italy, and Spain, with over 5,000 banks in its jurisdiction, had total assets equal to $6.9 trillion at the end of 2023, which is almost as large as the Fed’s balance sheet, clocking in this month at $7.2 trillion (Slide 11).