Economic Update
- Treasury yields reached 15-year highs across much of the curve in August
- Economic optimism and rising U.S. budget deficits have pressured long-end benchmark yields higher in recent weeks
- Community-based financial institutions are experiencing rising cost of funds and liquidity challenges, but profitability, loan growth, and credit metrics have held somewhat steady
Treasury yields reached 15-year highs across much of the yield curve in August with multiple factors contributing to the move. Overall, the economic data trends have surpassed expectations for more than three months and fueled the narrative that the Fed may indeed need to keep short-term rates ‘higher for longer,’ potentially leading to a higher long-run neutral policy rate. A common measure of this neutral, or natural, rate of interest in economic circles is r-star (r), a term that has emerged in discussions more in the last month than it has in over a decade. Loosely defined, r is the inflation-adjusted rate of interest that supports economic expansion at a target level of inflation. This metric is notoriously difficult to quantify in real time, but the general focus of market participants is whether this estimated rate is higher or lower than what is being priced into the term structure of interest rates at any given time. For example, market speculation that this figure will be higher in the future should lead to higher long-term benchmark yields, which are effectively forward expectations for short-term rates plus a term premium paid for greater interest-rate risk. Also pressuring intermediate and long-end yields in August was the Department of Treasury’s quarterly refunding announcement on July 31 that showed much higher funding needs for the government in Q3 and potentially beyond given rising budget deficits and other factors (discussed in the Current Market Themes portion of our August Monthly Market Update).
The difference between forward market pricing and Fed guidance has narrowed notably in recent weeks. Based on the June FOMC Summary of Economic Projections (SEP), the median fed funds forecast revealed a 5.625% terminal rate in 2023 and 100 basis points (bps) of rate cuts in 2024. In mid/late July, markets were pricing for no more rate hikes in 2023 and 150 bps of cuts in 2024, but as we begin September, the market is more aligned with the Fed. In his annual Jackson Hole speech on August 25, Fed Chair Powell offered no material revelations as to the current perspective of policymakers other than a firm commitment to return inflation to the 2% target rate. To get there, Powell said he and his colleagues still believe a period of below-trend economic growth, including a cooling of labor market conditions, will be necessary.
Even after considerable policy tightening and a mini crisis in the banking sector, the U.S. economy has remained resilient and in expansionary territory, albeit at a moderating pace. In the final week of August, the July JOLTS report revealed a significant drop in job openings to the lowest level since March 2021, and later that week, the headline unemployment rate rose 30 bps to 3.8%. However, the latter was attributable to a large increase in the official labor force as opposed to a decline in household employment. Growth in nonfarm payrolls exceeded expectations, and wage growth was in line with expectations.
What the path forward will be is a difficult question to answer for Fed policymakers and market participants alike. In the very near term, the Fed could justify another pause at the upcoming September FOMC meeting, but if the current data trend persists, it’s unlikely we’ve seen the final hike of the cycle. In reviewing the many uncertainties related to the economy during the Jackson Hole speech, Powell was adamant that “2% is and will remain our inflation target.” He also suggested that balancing the risks of doing too much or too little in the inflation battle is a complex task, but it would seem that Powell and the hawks of the committee are more concerned with doing too little at this point. This makes rate betting an even more perilous effort (and an unnecessary one for financial institutions) going forward. Markets are already priced for rate cuts next year, in line with Fed guidance from the June FOMC meeting. However, when the updated SEP is released following the September 20 FOMC meeting, the “dots” may very likely show less rate cuts in 2024 and beyond. At that point, market participants will choose whether to follow the more hawkish guidance, and if there are indeed no (or less) rate cuts in the near/intermediate term, then the entire Treasury curve would need to reprice accordingly.
Bank & Credit Union Trends
One major concern in the wake of the March bank failures was a tightening of credit conditions that would ultimately stifle economic growth. As noted in previous commentaries, the reduction in both demand for and supply of credit began in the second half of 2023 across multiple lending categories following record growth in the first half of last year. That trend continued in Q2, but as illustrated in Exhibit 1, loan growth remained in positive territory for community-based financial institutions, though at a slower pace relative to a year ago. The average cost of funds was notably higher over the quarter, but the average credit union net interest margin (NIM) was essentially unchanged at 3.37%. Average bank NIM fell 15 bps to 3.45%, both still above levels seen a year ago thanks in large part to higher asset yields and funding costs still lagging the market. On the credit front, the average percentage of delinquent loans held steady for banks at 0.59% and rose 11 bps to 0.63% for credit unions.
It’s likely still too early to wave the all-clear flag for financial institutions, particularly with the yield curve remaining steeply inverted. Some institutions lost sight of disciplined risk management amid the flood of monetary and fiscal stimulus in 2020 and 2021, and with marginal funding costs continuing to rise, it becomes more critical than ever to maintain discipline in all areas of funds management, including proper asset pricing in an ALM framework.
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