Fed Rate Outlook Looks Just Right for Banks
Banks look forward to relief on deposit costs, but have no desire to go back to zero rates
By Telis Demos
Fed Chair Jerome Powell delivered some welcome news to investors last week. PHOTO: AL DRAGO/BLOOMBERG NEWSWhen it comes to interest rates, banks need a Goldilocks scenario: Not too hot, not too cold.
The Federal Reserve looks set to deliver.
Surging interest rates gave banks plenty of headaches, to put it mildly, ranging from a rapid repricing of deposits to a plunge in the value of their longer-term fixed-rate securities.
Yet a sharp pivot toward lower rates wouldn’t have been great either, putting pressure on interest income from their shorter-term and floating-rate assets.
Fed policymakers last week left unchanged their median forecast implying three quarter-point rate cuts this year, welcome news as investors had feared they would dial that back.
They also penciled in three cuts next year, one less than previously projected.
Their expectation for the long-term federal-funds rate also crept up a bit, to 2.6% from 2.5%.
This slower, but long-term higher, scenario is rather ideal for banks.
A bit of the pressure comes off on deposit repricing and asset values for now, but banks can still look forward to stronger interest earnings over time, with less likelihood of an eventual return to ultralow rates that squeezed their fundamental ability to earn on lending and securities.
Also helpful for banks may be the Fed’s steady-eddie approach to adjusting its quantitative tightening, or the process of shrinking the Fed’s balance sheet.
Fed Chair Jerome Powell told reporters that the view of the committee is that “it will be appropriate to slow the pace of runoff fairly soon.”
He added that “slowing the pace of runoff will help ensure a smooth transition, reducing the possibility that money markets experience stress.”
What that means is that banks won’t have to worry quite as much about falling reserve levels and the related pressure on deposit levels as the Fed reduces its holdings.
The KBW Nasdaq Bank index rose 3.7% last week, topping the S&P 500’s bounce.
Further gains may be harder to come by, though.
Banks still face lingering concerns about credit risk, ranging from rising consumer defaults to whatever may ultimately play out in commercial property.
And then there is what is happening elsewhere at the Fed, and with other banking regulators, in the form of coming rules.
Required capital levels are bound to rise for the biggest banks.
Some revisions to the rules may soften the blow, but by exactly how much remains to be seen.
There are also still potential additional rules that would focus more specifically on the interest-rate risk that sparked the collapse of Silicon Valley Bank and others.
Plus, banks have now reclaimed a more typical valuation level, coming back from their post-SVB depths.
S&P 500 banks are now trading at a bit under 12 times forward earnings—roughly around their 20-year average, according to FactSet data.
Past periods when their multiple was consistently above that mark included the aftermath of the 2016 election and in the couple of years after the start of the Covid-19 pandemic.
This would suggest it would take something rather extraordinary for banks to trade significantly higher in the near-term.
Maybe a sharp resurgence in loan growth, boosted by lower rates, could deliver that.
Or, a quick decline in deposit costs.
History suggests that it takes time for depositors to adjust to changes in rates, meaning that upward repricing tends to continue past the peak of a rate cycle.
Bank investors are enjoying their porridge right now, but it is no time for a nap.
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