A Reset on Interest Rates

Hopes that interest rate cuts would provide relief for what ails banks have been replaced by a realization that rates might be stuck for a while or even rise.

John Engen
Contributing Writer

Remember the good ol’ days, way back in December and January, when inflation was falling, and interest rate cuts looked all-but certain? We could have six, maybe seven, cuts in 2024 alone, the thinking went. And those cuts would be a magic elixir for much of what ails a struggling banking industry, alleviating the pain of underwater bond holdings, compressed margins and shaky credit quality while reviving valuations and the M&A market.

Fast forward a few months and the question has changed from “How many cuts?” to “How high for how long?” Inflation has been more persistent than expected – the consumer price index rose 3.5% in March, up from 3.2% in February – and the economy continues to grow at a healthy pace. The case for near-term rate cuts no longer looks solid.

In an April 16 question-and-answer session, Federal Reserve Board of Governors Chair Jerome Powell didn’t sound in a hurry to do much of anything. “Right now, given the strength of the labor market and progress on inflation so far, it’s appropriate to allow restrictive policy further time to work,” he said.

Nor is there confidence Powell’s position could change anytime soon. Fed funds futures pricing data doesn’t project a cut until at least September, according to CME Group’s FedWatch tool, and with a polarizing presidential election on the horizon, analysts say even that looks iffy. Powell has been clear that he doesn’t want the central bank to get caught up in politics.

“It’s going to be tough to get the reassuring evidence needed to justify cuts by September,” says Diane Swonk, chief economist for KPMG US, who recently lowered her forecast from two rate cuts in 2024 to one.

Some have even suggested that the Fed’s next move could be up, not down, from today’s fed funds effective rate of 5.33%. Jamie Dimon, chairman and CEO of JPMorgan Chase & Co., warned in his annual shareholder letter that rates could jump to “8% or even higher” in the years ahead. “A scenario where the federal funds rate hits more than 6% would likely entail more stress for the banking system,” he wrote.

“What Do We Do Now?”
Bankers can’t be blamed for feeling whipsawed by the rapid change in sentiment about something so critical to their businesses. Many have large volumes of unrealized Accumulated Other Comprehensive Income (AOCI) losses on the books – much of it low-rate bonds purchased during the early days of the pandemic when banks were flush with deposits – and were counting on lower rates to minimize the impact.

Dan Bass, a managing director at Performance Trust Capital Partners in Houston, says “a lot” of his client banks started the year modeling for multiple rate cuts in 2024, and are now scrambling for a plan B. Even those who say they weren’t fooled by a too-optimistic forward curve didn’t expect to be confronting the prospect in 2024 of one cut or no cut – or worse if inflation reignites.

“We didn’t think there were going to be six cuts [in 2024], but we thought there might be two or three,” says Tim Crane, CEO of $57.6 billion Wintrust Financial Corp. in Chicago. “Now, the futures have a 20% chance that the next rate move will be up.”

Slowly, the industry is beginning to capitulate. “There’s a realization among many bankers that maybe rate cuts aren’t coming,” says Christopher Olsen, managing partner for the investment bank Olsen Palmer. “The question is ‘What do we do now?’”

Key Areas to Monitor
What happens with interest rates can touch almost every part of a bank’s operations. Several critical areas that bear special monitoring in a higher-for-longer scenario include:

  • Balance sheets: Banks had $478 billion in unrealized losses on their books at the end of 2023, according to the Federal Deposit Insurance Corp. The huge AOCI number hurts valuations and limits flexibility, and many bankers were hoping rate cuts would provide some relief. Some institutions will likely need to choose between holding onto low-rate securities longer than they want to or selling at a loss.
  • Margins: While higher loan rates have padded net interest income for some larger banks, pricing pressure on deposits has outweighed the benefits. In Bank Director’s 2024 Risk Survey, 78% of bank executives and directors said their institution’s net interest margin contracted in the last year. With rates stuck, there’s little reason to think that deposit costs and competition will decline.
  • CRE Loans: A large CRE maturity wall looms for some banks. Lower rates would make it easier to refinance those loans, potentially keeping default rates manageable while boosting spread income. “We don’t know at what point higher rates could break some of those loans and create a bigger credit issue,” says Stephen Scouten, an analyst for Piper Sandler & Co.
  • The M&A Market: In January, rate-cut chatter boosted optimism that the AOCI-driven gap in pricing expectations between buyers and sellers could be narrowed. Now, Olsen says, “more banks are starting to think about transactions with the assumption rates aren’t coming down,” with all the pricing implications involved.

Don’t Predict Rates, Model Scenarios
Swonk, a former chief economist for the old Bank One Corp., says these and other challenges have some bankers quietly hoping for a recession to hasten cuts. But a recession would likely be accompanied by job losses, higher default rates and other negative effects. “That’s not what banks want,” she says. “A recession would be much, much worse for banks than what we have now.”

Bass recommends that banks instead focus on things they can control. “Don’t try to predict rates,” he says. “Do a model with no rate cuts and one where rates drop 300 basis points so you understand what you would look like in different environments. You’d be surprised how many banks don’t do that analysis.”

Scouten suggests that banks consider making their balance sheets slightly liability-sensitive in anticipation of future rate cuts. He also thinks this could be a good time to enter out-of-favor businesses, such as mortgage originations, on the cheap. “Build for the long-term and weather the environment,” he says.

Olsen says many bankers have become too enamored with the idea that rate cuts can solve their problems. For example, what if the 10-year rate stays flat after a series of cuts? The yield curve might not be inverted any more, but bond losses would persist. “What if the Fed cutting rates doesn’t really change things?” he asks. “You need to have other options available.”


John Engen

Contributing Writer

John Engen is a contributing writer for Bank Director. He has more than 30 years of experience as a business journalist, writing for a variety of newspapers and magazines, and was a foreign correspondent for the Associated Press. He graduated with a degree in economics and international relations from the University of Minnesota and did his post-graduate work in Asian studies at the University of Hawai’i.