Trying to predict rate movements from the Federal Reserve right now is about as sure as sports betting. While there seems to be market consensus that rate cuts are coming, there is strong debate over when and how frequently the Fed will cut rates, and more importantly, what the driving factors will be.
Tariffs are a hot topic when discussing economic growth, slowing, and potential stimulus required, but predicting the direction and severity of tariffs is equally challenging. The recent imminent tariffs on Mexico were averted at the last moment, significantly shifting the predicted probability of movement from the Fed.
The chart above represents the predicted probability of the Fed Funds rate for the June 19th Fed meeting. Notice the current rate (green line, 225-250 bp) had a near 100% probability of no movement until early June, when tariffs on Mexico were announced. There seems to be market agreement that the Fed will not move rates during the June 2019 meeting, however, the market is less unified in its view of where we will be by the end of the year. Note the predictions for the December 2019 Fed meeting in the chart below.
At present the Fed seems to view the market as being well balanced between employment and inflation, but the market is getting mixed signals on the direction of the economy. For example, last week CNBC reported the following headline, “Jobs creation slows dramatically with payrolls up just 75,000 in May, much worse than expected.” Then, three days later reported, “Hiring by US businesses hits a record high.”
With such a lack of clarity around where the Fed will move over the next 6 to 12 months, how are financial institutions supposed to budget their cost of funds for the next calendar year? For nearly every financial institution, the largest expense on their income statement is interest (or dividends for credit unions) paid on deposits.
We at Nomis have a few suggestions and predictions for the 2020 budget cycle that will help you think about how to assess and assign budget for the coming year.
Keep in mind that “people” and “customers” are not segments, and different personas within your customer base will behave differently. Continued chatter in the marketplace around Fed movements will stimulate attention from rate-conscious customers seeking yield. These customers will be even more astute when looking for a place to park deposits and will also factor into their sensitivity for timed vs liquid deposits. For example, online searches for “money market” or “savings” or “CD rates” have spiked around each of the Fed’s rate announcements in the last 24 months, and a rate decrease will have the same effect of reminding rate-aware customers to check what APYs they can get paid.
To avoid placing customers into the binary and broad buckets of “rate-sensitive/ hot money” and “non-rate sensitive,” work with your marketing, data and analytics, and line of business partners to create and understand to a more granular level to what degree a customer is sensitive, then cluster those customers in groupings (quartiles for example). While some customers may move money for 10-15 basis points, they may also only work with traditional institutions, while other customers may only move for a 50+ basis-point differential and are willing to pursue promotional pricing and/or online pricing. A combination of customer survey and data mining on your outgoing ACH transfers to other financial institutions is a great starting point for tagging who these clients are, and what the mix of each customer type is for your shop. Once your team has a grasp on the mix of customers and your need for funding in 2020, you can start evaluating whether you expect your overall portfolio cost of funds to change in line with the previous 2-3 years, or whether you will need to spend more to attract and retain the deposits of clients that skew toward the rate-aware or rate-sensitive mix. Chances are, if you have a moderately to highly sensitive client base and your deposits have not kept up with loan demand to this point, you will need to accelerate your rate offering to retrieve lost deposits and gather new funding in 2020 and budget accordingly.
Separate your “on menu” and “off menu” pricing
During the current rate cycle, financial institutions have been highly reluctant to move the “base” or “menu” pricing on deposit products. This shift away from portfolio-level pricing has made rate subscription services and shopping across standard rate sheets much less effective than in past rate cycles. Most liquidity management is being done through off-menu promotional pricing for consumers and exception pricing for commercial clients. We expect the “on-menu” pricing will be flat or down in 2020, but savvy customers (business and consumer) will continue demanding yield and will move money to find it. Be prepared to offer aggressive, targeted offers to your clients to attract and retain balances. While there may be some flight-to-safety money movement if the stock market takes a turn, the more likely scenario will be that 0 to 2 rate cuts by the Fed will be an indication that the economy is still reasonably well balanced, and we will not see the exodus from the equities markets like we saw in 2008 and 2009.
Evaluate your lending forecast
The most important factor in determining your cost of funds isn’t the Fed funds rate; it’s your loan-to-deposit ratio and your institution’s need to fund lending activity—especially if your institution is dependent on borrowed or brokered deposits from FHLB or third-parties. Lending activity continues to grow and competition for deposits continues to increase, with higher rates being paid especially by the super-regionals, regionals, and smaller banks. Given the need for deposit funding, banks may not be able to lower rates much following the next Fed funds rate cut, which would be good news for consumers.
Review your capabilities
How sophisticated and data-driven is your deposits pricing mechanism? How capable is your institution at offering specific pricing to relationship clients? How easily can you create and deploy promotional and exception pricing schemas? If your financial institution has an antiquated process for setting rates and typically delivers offers with broad brush strokes (either through portfolio price changes or “shotgun” approach deposit gathering campaigns), then expect your cost of funds to increase in 2020 in a similar trend to 2018 and 2019. Institutions that have implemented advanced pricing and delivery tools will likely see an advantage in their cost of funds of 3-5 basis points on a blended portfolio, as compared to peer institutions.
If your institution is able to deliver specific offers and lower “on menu” pricing, you may be able to hold cost of funds flat for 2020. If your institution is able to deliver specific offers and lower “on menu” pricing, you may be able to hold cost of funds flat for 2020.
Read more on how to optimize your deposit pricing or leave a comment below to keep the conversation going.