Don’t Overthink It – The Current Environment May Not Be As Uncertain As It Seems

Although it may feel like the operating environment is in constant flux, driven by the war in Iran, a new Fed Chair and fluctuating inflation, it may actually be much less volatile than you think. If we separate the headlines from the real impact on the business, the constant on-again, off-again nature of the activities in the Middle East may be far less unsettling.

Potential Impact on the Business of a Community-Based Financial Institution

Let’s examine the impact of three separate scenarios, and for sake of argument, let’s call them the best-case scenario, the worst-case scenario, and the most likely scenario.

Best-Case Scenario

Let’s start with the best-case scenario, as this one is relatively easy to evaluate. This assumes that the war is over in short order, in the next month or so, and as a result, crude oil prices decline while dragging inflation expectations with it. Gas prices will come down, but it will take a bit of time to wring the inflationary pressures from the system, but the worst has been avoided. Market expectations for Fed activity, which based on recent Fed Fund Futures contracts was two hikes of 25 basis points by early 2027, switch to potential cuts down the road. In this scenario, it could be argued that the operating environment could revert back to the pre-war period in early 2026, when the market expected a cut in 2026.

If this were to play out, the decline in inflation expectations would likely remove upward pressure on deposit costs, leading to a decline in deposit rates, including CDs, high savings and money market accounts, and Brokered CDs. Once again, if we go back to early 2026, the expectation of a Fed cut applied downward pressure to funding costs, but once that flipped due to the rise in oil prices, the pressure was applied in the opposite direction. That would be reversed.

In addition, and perhaps possibly the most important outcome of a quick end to the war, sentiment would improve dramatically. The overhang of concern would decline significantly, and borrowing activity would likely improve. The big negative may be tighter liquidity as depositors withdraw money to invest in the stock market, which would likely get a boost.

Worst-Case Scenario

For this exercise, this will be our worst-cast scenario, although we all know that things can always get worse. The expectation here is that the war will rage on for an extended period, leading to significantly higher oil prices that pressure inflation, and eventually, Fed rate hikes. Under this scenario, let’s assume the Fed must hike 100 basis points over the next year to combat inflation. This would impact deposit and borrowing costs, with CDs potentially rising to over 5% while overnight borrowing moves to nearly 5%. This would pinch margins, as while loan rates would climb, demand would fall as business owners could be reluctant to take on newer debt at levels approaching 8%.

Under this operating environment, would business grind to a halt? Would you cease all lending activity and hunker down for the next year? Of course not! Even under this scenario, business continues but certainly gets a bit tougher. Demand will be lower, margins will tighten, and credit may become a much bigger concern, but liquidity may improve. The stock market would likely become more volatile, leading some people to bring money back to federally insured depositories.

The outcome here would be significantly more challenging than the previous scenario, but the show must go on, as they say.

Most Likely Scenario

This one may be obvious, but the outcome falls in the middle of the two discussed above; the war ends in the medium term, before the Fed needs to act to control inflation, but not so quickly that we avoid additional short-term disruptions. In this case, rates may continue to be volatile, but in a relatively tight range, before declining once the war ends. With the 5-year FHLB near 4.50% and the 10-year Treasury near 4.70%, loan rates appear attractive even with marginal funding costs above 4%. Overall loan demand remains decent-strong, although it varies by region.

Margins may tighten as we near the end of 2026, driven by upward repricing of the majority of maturing CDs, but overall business conditions remain solid, even with the constant ups and downs of the war.

What Are The Takeaways From This Exercise?

The key point to consider is that whether the operating environment improves significantly or moves in the opposite direction, business fundamentals should remain similar in each of the scenarios.

• Even in the worst-case scenario, with rising deposit costs and likely only slightly impacted credit conditions, increasing loan yields will offset a portion of the impact, so although we may face tighter margins, many financial institutions have built some cushion to buffer against this.
• Loan pipelines appear strong currently, which should also provide some cushion, at least for the next quarter or so.
• None of the scenarios are bad enough that lending would cease; rates may move against you, but unless the operating environment deteriorates significantly more than expected, activity will continue.

All scenarios indicate a continuation of business activities as you ignore the noise to the extent possible. Depositors will continue to roll CDs, borrowers will continue to pay their debts, and while operating conditions may deteriorate at bit, business will move forward.

Ultimately, while the range of potential outcomes may be wide, the practical implications are more manageable than the headlines suggest. Community financial institutions should continue to remain flexible, stay focused on fundamentals, and avoid overreacting to short-term uncertainty.