Addressing the “Higher for Longer” Rate Environment for the Balance of 2024

Now that we are officially in the ‘higher for longer’ operating environment, how does that impact the balance sheet strategy for the remainder of 2024? Are there tactics that can be implemented in the short term to mitigate the impact of continued higher rates? Although most would prefer Fed easing to happen much sooner, we need to prepare and expect that the Fed Funds rate will remain near current elevated levels for an extended period.

Strategic Approach in the Current Environment

Actual year-to-date results for 2024, as well as projections for the remainder of the year, are near the lowest we have seen in quite a long time. Although there are a number of key drivers of the suboptimal performance metrics, funding costs jump out as the number one concern.

Funding Environment / Options

Although migration from cheaper non-maturity deposits to higher cost CDs continues, the pace seems to have slowed. However, the decline in NMD concentrations over the past year or so has left institutions with a more expensive, and more rate-sensitive deposit mix overall. The fight for CD money continues and is in a similar place to where we were a quarter ago, with ‘higher for shorter’ pricing dominating the industry. Higher yield savings and money market offerings have been effective at retaining funding, but generally not at generating significant new dollars (without cannibalization) in short order when needed.

There also seems to be a renewed focus on commercial deposits, and although this is nothing new, institutions appear to be more aggressive about pricing with regard to the overall relationship, specifically offering better loan terms in order to secure the much-needed funding. A component of this strategy requires help from the Fed, as an underwater loan rate offered to bring in operating account money looks much better over time as rates fall, making the existing loan rate more appealing in comparison.Certain types of wholesale funding, although expensive, remain attractive compared with overnight funding near 5.5%. A case can be made for each of the following, as a modest component of a larger funding strategy:

Option Advances:

For a modest amount of call risk, this funding source can provide a much-needed benefit to strained margins. For example, a 3-year non-call 3-month advance was recently priced near 4.35%, about 100 basis points under overnight funding. With the Fed likely on hold until much later in 2024, combined with a modest easing cycle thereafter and a potential terminal rate of 4%, this could be margin-positive for nearly half of the original term. Plus, if the Fed stops at 4% on the way down, it may be only slightly underwater for the remainder of the term. If called, it could be rolled into another advance, or potentially not if deposit growth improves. A case can also be made for a small allocation to 5-year funding, as long as the rate is under 4% and you believe the Fed is likely to stop at 4%. In this case, the advance could remain margin positive/neutral through most of the 5-year window. This is certainly not a long-term solution, but more a stopgap that buys time until the operating environment improves, when the potential above market cost (assuming advance not called) can be more easily absorbed vs. the need to help margins today.

Brokered CDs:

Although rates on short-medium-term funding are only slightly below overnight funding, Brokered CDs do not use up precious borrowing capacity. With most institutions trying to lower borrowing concentration, these may be appealing, even if they look and act like borrowings.

Lending

Before the most recent runup at the longer end of the Treasury curve, competition for Commercial Real Estate lending had pushed rates into the 6.50%-6.75% range for many institutions. However, more recently that range appears about 50 basis points higher on average, with some able to generate activity a bit above that. Most institutions remain active with deals available, although some continue to pull back by pricing themselves outside of the market. The theory is the same as the last few quarters, even with the Fed now on hold for longer than previously believed. Although overnight funding remains near 5.50% and will likely be there for some time, a high credit 5-year CRE loan at 7% remains attractive. Although the spread is below normal levels, that should improve as rates decline later in 2024 and into 2025, and from a pure rate standpoint, this may be the last, best time to lock-in attractive yields before the decline. Unless your borrowing concentration is prohibitively high, lending at 7% seems a more beneficial alternative to paying down wholesale funding or maintaining excess liquidity. Similar to last quarter, the residential mortgage market remains slow, with people who want to move still ‘trapped’ in their homes by their low rate, pandemic-era mortgage. This has led to a pickup in Home Equity activity, but certainly not enough to offset the lack of mortgage demand. This has resulted in increased CRE competition as institutions realize that if they want to grow their loan portfolios in 2024, it will not be in the mortgage area.

Financial Performance and Expectations for 2024

On the whole, business plans for 2024 assume very modest growth for loans and deposits, with many forecasting declines over the next year. In addition, the financial projections indicate historically low earnings, including many institutions bracing for losses this year. Driven by continued NMD migration and higher-for-longer rates, coupled with still high (but declining) borrowing concentrations, many are already significantly behind budget for 2024, with likely little possibility of making up lost ground. The question now becomes, how important is it to hit budget, and based on that answer, what are we willing to do to get there?

The answers to those two vital questions could drive strategy for the remainder of this year, but also more importantly, impact earnings for years to come. For example, consider the 5-year Option Advance discussed previously compared with overnight funding costs, it could save 150bp or more for a sizable portion of funding, which could be enough to push earnings from marginally negative to marginally positive. However, that benefit supplements current earnings by essentially ‘stealing’ from future earnings; if rates decline more than expected, that advance will likely extend, leaving you with above market funding, potentially for years.