On July 30, the Federal Reserve announced a 25-basis-point reduction in the federal funds rate. Federal Reserve Chair Jerome Powell characterized the move as an “insurance” cut to help extend what is now a record-long U.S. economic expansion amid economic headwinds related to a slowing global economy and an inversion of the yield curve, which many market participants view as a warning signal of a looming recession. Even so, a little less than two weeks removed from the interest rate cut, the yield curve inversion persists. Herein lies the challenge for banks.
As the yield spread above indicates—despite the decrease to the Fed’s policy rate—longer-term rates have continued their downward trend amid worsening macroeconomic conditions both domestically and globally. That economic deterioration will likely cause the Federal Open Market Committee to act again in September, and possibly once more in December, resulting in an additional 50 basis points of rate cuts.
The potential for additional near-term rate cuts from the Fed aside, the fact remains that if longer-term rates continue to decline, banks will be faced with further pressure on their net interest margins. Regardless of whether banks have their floating rate loans tied to longer-term rates, such as the five-year US Treasury or five-year FHLB advance rate; or to shorter-term rates, such as the one- or three-month LIBOR, they all have all been moving in the same direction—lower. And unfortunately for most banks, the reality is that their loans will reset quicker than they can reprice their deposits.
Smaller banks most at risk from lower rates
Smaller banks may be most vulnerable to a backlash from declining interest rates, as they typically don’t have the diversified operations of their larger rivals to generate more fee-related income, nor do they deploy hedging strategies to mitigate rate effects. As a result, the impact of lower rates to their bottom line will be more profound than that of larger peers.
Banks that have the ability to lower their funding costs in advance of pending rate cuts and institute variable rate loan resets would stand to benefit as longer-term rates continue to fall, compared with those banks that cannot.
As banks look toward the future, they will likely have to adjust to a new norm of lower rates and increased competition across not only the asset side of their balance sheets but also the liability side.