We are at an interesting inflection point in the current economic cycle. 8-10 years into a long upswing and most economic indicators point to the positive momentum continuing, though potentially not as fast as it had been the last few years.
That said, there are both political and economic reasons for the cut, but let’s stay away from the why this happened as that has been discussed ad nauseum, and focus on the so what, now that short term rates have dropped by 25bps.
The market had this drop priced in for a long time, so don’t expect anything major to happen there.
Markets do love certainty though, so with the uncertainty of will it be 25bps or 50bps question settled, there is more certainty in the market so a minor uptick should occur, all else being equal, which of course it never is, especially with a trade deal with China looking farther off now than it had been in the past.
How does this impact banks and their customers as well as the rate options of various products?
There are three core rates to look at, deposits, mortgages and home equities and they will all behave differently with this change.
First, deposits rates are driven by two factors: the first being short-term rates from the Fed and the cost of alternative sources of funds tied to the Fed rate. The second driving factor is the need for loan funding at the financial institution. A lowering of the Fed’s short-term rates should drive down deposit rates, but any downward movement will be constrained by the need for deposits. With the economy still strong and competition for deposit dollars high we expect the majority of banks will hold deposit rates relatively flat. Banks with the lowest loan-to-deposit ratios will be best positioned to lower deposit rates and cost of funds in the near term.
The interplay between home equity and mortgage is extremely interesting. Early in the rate cycle when Prime was at 3.25, Home Equity lines of credit were sky rocketing. They were cheaper than a Mortgage and they were free. Since then the landscape has changed dramatically in the latter part of the current cycle.
Prime has continued to rise making home equity rates more expensive and the 10-year treasury has come down from ~3% in January to hovering around 2%, making mortgages cheaper than equities. Even worse for home Equities, changes in the tax laws this year make the interest non tax deductible, so now you have higher rate variable loans without an interest deduction.
Interestingly, during the current cycle the Fed has only increased rates until now, and when the Fed rate, i.e. “short term rates” increased, long term rates have decreased causing re-fi volume to spike as equities dry up.
Simply put when rates have gone up Home Equities have gotten more expensive and Mortgages have gotten cheaper. A cash out re-fi is an alternative to a Home Equity and is typically a fixed rate vs a variable rate so in essence, low risk fixed rates have been cheaper than more risky variable rates, which is counter-intuitive and has really hurt the Home Equity market.
Will the inverse hold?
Now that the short-term rates have come down, will the long term rates go up? I don’t believe data from previous economic cycles will help us answer that question in this unique economic period.
Of course, bank profits increase as the yield curve widens out. Steeper yield curves equate to more profits for banks. Product by product though the reduction in Home Equity rates that happen immediately with the Fed Funds rate drops will not be enough to catch up to the very low cash out refi rates, so while Home Equity gets a minor benefit it will not be enough to turn around volume projections for the rest of 2019 or even 2020. That said customer’s that waiting on the fence to get a Home Equity, this may be the chance.
Looking ahead no one knows where the 10 year will go, but keep in mind even if it goes all the way back up to 3%, we will still be in an environment where cash our refi’s are more competitive in rate than HELOC’s, plus the customer gets to fix their rate and get an interest deduction on their taxes.
So what should you do and how should you price?
First off we need to shift our thinking away from products and more towards solutions. Many things hold the industry back form this, including loan officer compensation potentially favoring one product over another. We need to forecast home loans as one industry with Mortgages and Home Equity as two counter cyclical sides of a coin and get to the point where we underwrite the customer not the product and get them the best solution for what they are looking for. Pricing is one major way to tackle this, looks at balance sheet impact and yields of Cash out refi’s and HELOC together and price accordingly to the economics and needs of your bank. Do you need more short-term variable assets or longer-term fixed assets? There is a supply side and a demand side to pricing, but there is also a strategic side of this, and every bank has a different balance sheet strategy and these strategies should shine though in your pricing. Additionally, you should be able to adjust the tactics that help you get to this strategy on the fly.
Back to internal bank economics. When yields widen, profits go up and times are good. Your peers are going to use these extra profits to invest even more heavily in technology as well as passing some benefit back to the customer resulting in tighter margins and more competition. Don’t be left behind, make sure your technology budget is strong and you have the tools to adjust tactics on the fly to hit your long term strategy.
How do I advise my customer on what rates are going to do?
Stop speculating and focus on solving the customer’s problem. Mortgage rates are just as likely to go up and cost your customers thousands of dollars in interest as they are to go down. Sell your float down option to the customer and make them feel safe. If they like the deal on the table, they should take it and know if rates decline there is some safely net to catch them. Advice I always give customers is lock in now if you like the deal on the table, don’t speculate. And banks should not speculate either. Optimize prices and tactics on the ups and downs of the market and you will net out ahead in the long run, don’t try to guess, it will only cause you to miss your forecast and hurt bank earnings and the customer.
Looking for more insight? Check out our latest post on how to grow your deposit portfolios in an unstable market.