As interest rate cycles go, it’s been a long one, and a 25 basis point increase is not a clear signal that the era of “exceptionally” low rates has ended. Low rates have literally re-written how things work. We remember in 2008 watching rates fall below 50 basis points and wondering how money market funds could operate with investment returns on short term debt below even a modest fund management fee. Who could have predicted that Bank of America would sell its $87 billion money market fund operation because it lacked scale and profitability?
Money funds aren’t the only financial model to fall victim to near zero rates. Of greater import is the undermining of the pension and insurance models. Both make promises based on real economy factors such as worker salaries and mortality rates and must make good on those promises even though investment returns are inadequate in the low rate environment for these promises to be kept. US problems seem bad, Europe’s are impossible.
The 25 basis point increase by the Federal Reserve is just a start at normalization. It’s worth considering the positive things that happen when short term rates rise.
- At 50 basis points Money Funds and Short Term Bond Funds can start to compete again.
- At 100 basis points Non-Interest Bearing Demand Deposits tied to branch networks start to make sense again.
- At 200 basis points pension, insurance and annuity schemes work better.
The latter might work better only on a go forward basis. The mark-to-market effect on existing portfolios will likely reveal the inadequacy of current assets.
Whether or not short term rates actually make it to 2% in the next two years will in Fed Speak be “data dependent.” How vigorous will the currently vibrant US economy continue to be? In most years two outlook scenarios would cover much of the probability, but this year we have to think in threes. The spectacle of the imploding commodity complex centered on a now stagnant China is too significant to ignore if you are bullish. A US economy creating jobs and creating households is too significant to be ignored if you are bearish. The third scenario, a bastard result of the first two, should be considered equally likely.
The most bullish case was made recently by a Richmond Federal Reserve economist. The bullish probability is based on job growth unleashing a wave of new household formation pent up by the financial crisis. Although higher rates tend to dampen housing, this economist argued that slowly rising rates will push a wave of young, now employed buyers off the fence into their first home ownership and higher house prices will free up the bulk of America’s remaining underwater mortgages. Lower energy prices and a strong dollar will fatten the pocketbooks of American consumers and together with household formation will drive consumption led American growth. The one fly in the ointment is a lack of rising wages for the middle class, but many expect to see gains as the economy sustains full employment.
It is hard to deny that something like this is already happening in our cities with favorable demographics. Washington, San Francisco and Southeast Florida are three anointed, yet diverse, areas that are booming. The community banks in these markets are beginning to bulge with new lending.
At the other end of the spectrum are those that believe the Fed is about to raise rates just as the world economy’s wheels are coming off. The collapse of the commodity complex, particularly the inability of oil to find a bottom, is a sign of a profound emerging market recession, led by and including China. A strong dollar will harm the competitiveness of US manufacturing and agricultural exporters even as overseas markets offer up less demand. The performance of US based multinationals will be challenged.
It is equally hard to deny this dynamic is already happening with the only uncertainty being the magnitude of the impact on the US. At the time of the last Asian crisis in 1996-97, China manufactured and consumed fewer than 6 million automobiles per year. Last year China manufactured and consumed 18 million, more than the United States. Between China, the oil producing nations and the commodity focused producing nations, there has been a major, demand-sapping adjustment. Debt problems usually follow such events, particularly when the dollar is getting more dear in foreign currency terms.
The bears argue that whatever restraint the surging US economy needs will be provided by currency headwinds and demand destruction in the emerging markets. The Fed’s action on rates will thus be additive and may stifle the expansion.
For those that waffle, the third outlook is a wobbly path for the US between the positive and negative scenarios. It is something we have already seen with the Federal Reserve moving to raise rates in September only to pull back when world markets shook. Now in December the focus has moved passed a 25 basis point rise to focus on when the next increase may come. The immediate impact of a rate increase is negligible in terms of increasing the cost of credit. The focus is currency changes, future rate increases and who will be caught out by rapid trading moves.
For those of us that follow banks, the 25 basis points is meaningful. The banking industry is a little bit like the money fund business. There is a certain amount of overhead that must be paid for regardless of interest rates. Extremely low rates challenge the business model making it hard for even well run banks to make returns commensurate with the cost of capital. Historically, the first couple of years of rising rates has widened bank net interest margins.
Market prices for banks substantiate the belief in the two track economy – US strong, World weak. The Nasdaq Bank index, which is dominated by large cap regional US banks, is up 10.0% year-to-date, while the S&P 500 Bank, which is mostly the very large banks with international exposure, is up less than 4.1% year-to-date. The idea that US regional banks are a pure play on the dynamic domestic US economy seems popular.
For community banks the right response to a modestly ramping interest rate period will likely depend on the robustness of the market served. In dynamic city markets like Washington with job growth and household formation, loans will be more plentiful than years past, but deposits will not. A willingness to be a little aggressive on rate with deposit gathering and stingy on low relationship investor CRE may be more rewarding to the top line than trying to squeeze every dollar of earnings by holding back interest expense. It also may make little sense to invest in additional branches, when the bounty of a good environment is likely to belong to the best entrenched producers.
In less dynamic markets, it may be easier to capture margin expansion and bring it to the bottom line. Greater earnings can be deployed into buybacks or be used as justification for a higher price in a sale. Deposit rich banks from areas with less growth may find more suitors looking for core funding, which should improve market prices.
Our feeling is rates will rise, but slowly, delivering some benefit to bank margins, albeit loan floors will limit the initial benefit. Some geographies of the US will suffer more directly from the commodity complex decline, while others will benefit from lower energy prices and a strong dollar. One of the best hedges against rising rates will be banks with strong deposit franchises. This has already spawned investor interest, which is likely to continue. Many banks, having suffered through the extended down period, are likely to avail themselves of the better pricing environment to sell at good premiums.