Beta Omicron - Episode 24

last updated on Tuesday, December 7, 2021 in General

Hello and thank you for joining us for another episode of The Insider, a monthly podcast production of the Federal Home Loan Bank of Des Moines and your source for industry news, strategies and key information about the bank. This is your host, John Biestman, Senior Relationship Manager.

Overhead at the local coffee shop, two high school astronomy buffs observed, “If there’s Alpha Centauri and Beta Centauri, when are they going to release the full game?” Sorry folks, but that’s a good lead in to what many financial institutions are pondering these days: the game of assuming deposit beta levels, let alone omicron’s uncertain impact on balance sheet risk.

Financial institutions have always been defined by their maturity transformation abilities. That is, their ability to successfully gain a spread between borrowing short-term and lending long-term. Maturity transformation requires assumption of interest rate risk, a large potential source being an unexpected increase in funding costs if your liability rates are re-setting at a faster rate than your assets.

Before the onset of the pandemic, historically unparalleled Federal Reserve monetary ease and ensuing deposit growth, it was simpler to develop justifiable beta assumptions. As rates have remained at low levels, the proportion of non-maturity deposits as a percentage of total deposits has never been higher. Financial institutions have been taught to do the right thing in developing justification for deposit inflow and outflow assumptions. Most support these assumptions through monitoring historical data and employing a variety of qualitative observations, including: changing distribution channels (i.e. technology), competitiveness of the market for deposits as well as deposit alternatives, a flat yield curve and low rate environment perhaps altering the impact of early withdrawal penalties, and of course those forever elusive estimates of the degree of “surge” deposits.

Going back to our primary courses in corporate finance, enter the science and art of estimating the degree of deposit rate changes to market rates, dubbed “beta.” As I alluded to, beta levels can be dependent upon so many variables, including: the level of current rates, yield curve slope and the degree of rate changes that are modeled. At least up until Thanksgiving week-end, market sentiment was leading to the scenario of several Fed rate hikes throughout 2022 in the wake of disturbing inflation readings. Just before Thanksgiving, on November 24, the Fed’s preferred year-over-year inflation gauge, personal consumption expenditures ex-food and energy, rose by 4.1%. To add insult to injury, including food and energy, the index rose by 5.0%. That’s a far cry from the upper edge of the Fed’s long-stated guidance of 2.0%.

So, at this point in the cycle, deposits have, or should have been priced to as close to zero as possible. Financial institutions have needed to re-price at a faster rate compared with the downward yields they have sustained on the asset side. If we are to interpret the Fed’s recently stated intention to accelerate the tapering of its balance sheet purposes, we could be at the start of a tightening cycle.

Thanks to S&P Capital IQ, I regressed deposit rates against the Fed Funds rate since the start of 2018 for commercial banks ranging in size between $500 million and $1 billion in assets. The industrywide cumulative deposit beta — the change in banks' deposit costs against the change in the effective Fed funds rate during the period — was 15.2% as of the third quarter of 2021. It should be no surprise that since the start of the pandemic, banks have been far more able to drop deposit rates at a faster rate than market changes. However, a key question remains: To what extent will institutions need to reprice deposits once market rates increase? As long as rates remain relatively low, the answer to this question should not be problematic, up until the point at which savers become rate sensitive. Perhaps deposit betas could remain low for a while, at least after a rate hike-or-two, because of the large amount of system liquidity. However, when that tipping point comes, it will be a good idea to have layered in a bit of duration-certain funding.

Prior to the 2021 Thanksgiving holiday, the 15th Greek letter, Omicron’s claim to fame was its use in the field of astronomy to designate the 15th star in a constellation group. Now, enter Omicron’s role in public health and, by default, into the realm of financial markets. In a matter of a holiday week-end, the yield on the ten-year Treasury dropped by 15 basis points. Pre-holiday, a support level of 1.75% was very much coming into view. Between the Wednesday and Friday of Thanksgiving week, break-even inflation markets, a good proxy for inflationary expectations dropped by 11 basis points. With the unknown impact of Omicron, many are now asking themselves a key question, “Will Omicron now perform the tightening that the Fed has heretofore been hesitant to do?” We’ll find out that answer in the coming weeks as we know more about Omicron’s potential impact on consumer and capital spending, inflation and job growth.  

Whether the impacts of Omicron or anticipated Fed rate hikes throughout 2022 temper inflation, financial institutions may take some time in raising deposit rates. We know that the timing of deposit rate increases (it’s hard to believe that I’m bringing up the subject) will be highly dependent upon the liquidity environment. The Federal Reserve H8 report of November 26 provides some interesting indications that while bank markets are still quite liquid, it became less so between the second and third quarter. Holdings of treasuries and agencies, moderated their growth from 21.7% annually and seasonally adjusted, during the second quarter, to 14.6% during the third quarter. Deposit growth similarly moderated, from 14.1% to 8.5%. Loan growth, bolstered by consumer and real estate lending, went from a decline of 0.1% to a growth rate of 2.5%. Finally, the annualized decline in bank borrowing moderated a bit. The third quarter drop in borrowings was -1.4%, versus the second quarter decline of -2.6%. There is some evidence that positive loan growth is gaining momentum during the fourth quarter. Hovde Group recently wrote that outside of the nation’s top 25 banks, loans have grown by 0.6% thus far in the quarter, noting that the quarter historically carries strong seasonal growth.

Since the start of the pandemic, the personal savings rate as a percentage of disposable income has been as high as 32%. The personal savings rate has been on a steady downward march since March of this year, from a high of over 26% to the latest October recording of 7.3%. Over the past ten years, a “normal” savings rate has been considered to have been in the range of 6% to 8%. So, perhaps the distortions from government stimulus checks and pandemic-induced spending restrictions have pushed the savings rate back toward normality. Think about your deposit balances and the impact that inflation could have on them. Will depositors remain satisfied with low yielding balances at a time when rising prices induce consumers to spend now for fear of prices of goods and services only to rise later on? Should further reductions in the savings rate take place, that could be a harbinger of reduced deposit balances. Watch these indicators. Still, we know that the ultimate wild card is the 15th letter of the Greek alphabet.

The CME Group posts an interesting FedWatch tool on its website that regularly calibrates the Fed Funds futures market and translates it into implied probabilities and magnitudes of future Fed rate hikes. It’s worth checking out at least once a week. It even features a countdown calendar for the next FOMC meeting for those insomniacs that prefer to count in reverse. Whereas the odds of a rate hike were over 98% before Thanksgiving, they are now in the range of 94%. So, quite a mixture: the prospect of tighter monetary policy, inflation, slowing global economic growth and the perils of the Greek alphabet.  

In an environment where one day the focus is on inflation and on the next day is an unknown variant, with so many unknowns, it’s tough to make a rate call. I remember speaking to a bond trading friend many years ago who responded to may question on the direction of rates. I will never forget his reply, “John, markets trade in one direction and it’s neither up nor down. It trades in the direction of where it hurts the most people.” Your job is to find out how many more people get hurt under different scenarios.” Notwithstanding this rather sober view of the world, you can often count on two by-products of uncertainty: added volatility of returns and higher required rates of returns. Your best strategies during conditions of uncertainty:

  • Map out the impact of macro-events on your liquidity, interest income and market value of equity. Know thyself when it comes to your balance sheet. Always be in a learning mode when it comes to your unique balance sheet and operating metrics and how they would react to whatever scenario is sent your way. Throw in a black swan event or two.
  • Diversify your assets AND your funding. As Don Musso, CEO of the advisory firm, FinPro underscored in our latest “On the Record” podcast, irrespective of your liquidity situation, it’s best to add some duration-certainty to your funding mix and consider mitigating your interest rate risk with advances.

As we brace ourselves for yet another unwelcomed recitation of the Greek alphabet, I was asked at the Thanksgiving table a question by a precocious grand- daughter, “What do you call a restive and mildly aggressive, orange vegetable?” The answer of course, was “beta carotene.”

Stay well and we’ll see you next time on the FHLB Des Moines Insider Podcast. Here’s to better betas! Thanks for tuning in.


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