There has been much commentary of late concerning the Federal Reserve’s perceived independence and the central bank’s ability to enact policy decisions amidst political rhetoric and fears that the current rate-raising campaign by the Fed could inadvertently short-circuit economic growth. In late September, the Fed raised its benchmark rate another 25 basis points, marking the eighth quarter-point rate increase since the U.S. central bank began raising rates in late 2015. At the same time, the majority of the Federal Open Market Committee (FOMC) signaled strong consensus with regard to another rate hike before year-end (presumably in December), and the possibility of three more increases as we move through 2019.
A few months ago, we touched on the relative shape of the yield curve, and the possibility of an inversion (short-term rates effectively moving higher than long-term rates, often graphically depicted in the spread between the 2-year and 10-year Treasury rates) predicting an oncoming recession. Many leading economists and ardent market watchers continue to debate if the next economic recession is right around the corner or possibly a few more years down the road.
For demonstration purposes, going back to the beginning of 2015, the following graph overlays rate increases enacted by the Fed (pink bar graph); the existing spread between the 2-year and 10-year U.S. Treasury rates (blue line); and the relative percentage change in the KBW bank index since year-end 2014:
The graph is not intended to necessarily point to any specific causation with regard to any interrelated movements in interest rates and corresponding spreads vis-à-vis bank equity prices. Historically, for the banking sector, rising rates have correlated to healthier margins (to a degree), until economic growth slowed, and rising credit costs surfaced. But, historical context is difficult to gauge in that the current spate of rate increases is coming on a baseline of objectively low rates and corresponding unemployment measures that have rarely been this healthy. As the graph above depicts, bank stock prices skyrocketed after the Election in late-2016 and continued to rise through 2017, but have generally trended sideways through most of 2018. Some momentum appears to have been regained as Q3 earnings announcements hit the wire, often reflecting performance metrics exceeding expectations while also subtly underscoring the relative continued strength and resiliency of the economy. Also, of note, as short-term rates steadily increased over the past nearly three years and spreads slowly compressed and flattened the yield curve, of late that oft-referenced 2-year vs.10-year Treasury spread has ever so modestly widened. A month ago, the spread had narrowed to approximately 20 basis points — today it measures roughly 30 basis points. Not necessarily cause for a ticker-tape parade as it is barely discernible, but nonetheless noteworthy amongst all the chatter in the markets.
Tax cuts and fiscal stimulus in the form of government-spending increases have accelerated equity accumulation on the balance sheets of most banks, giving organizations greater flexibility with regard to their capital management and shareholder-oriented deployment programs. And while the U.S. economy seems to still be firing on all cylinders, that is not to say that potential storm clouds are not forming — the growing federal deficit; potential inflationary pressures; rising rates leading to funding challenges for the industry; the unintended consequences of trade tariffs and potential trade wars; a presumably maturing credit cycle; ever-present and as-yet unknown geopolitical risks, etc. All currently appear to be far enough out on the horizon as not to be causing any immediate trepidation. But, they are forming, as economic cycles are inevitable. Ideally, as we’ve stated in the past, they just need not be catastrophic.
Returning to our opening comment regarding political pressures as the Fed charts it course, it is important to keep in mind that these criticisms are not exactly unprecedented as the U.S. economy has rolled through economic cycles. As one market analyst recently opined, such criticism usually meant that the Fed was doing something necessary, albeit unpopular. The most recent FOMC statement clearly highlighted a continued diligent and prudent approach to monetary policy objectives:
“The Committee expects that further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2% objective over the medium term. Risks to the economic outlook appear roughly balanced.”
And, as it pertains directly to real or perceived political pressure, Fed Chairman Jerome Powell’s recent comment was not only draped in logic and common sense, but also both simple and succinct:
“We just try to do the right thing for the medium and longer term for the country….we don’t let other things distract us.”
Candidly, I’m of the opinion that sometimes these public pronouncements concerning frustration with the Fed are not necessarily a bad thing. In essence, they would clearly seem to signal to the global economy that the U.S. financial system continues to be by-and-large respected and highly-regarded around the world, by subtly underscoring that monetary policy operates independent of any pressure from our political establishment. Count me in as a fan of the Fed maintaining its integrity as, per Chairman Powell, they “just try to do the right thing.”
How this will all unfold in the coming months and years remains to be seen. A significant unknown lies in the observation that while the Fed has been raising rates on the short-end, with little discernible movement on the long-end, this has all been happening in an already low-rate environment. How much and how quickly the economy slows (and for how long) is a bit of a wild card. While the Fed assesses and implements expected interest rate hikes as we close-out 2018 and move through 2019, a continued ardent focus on credit and interest rate exposures remains the order of the day. For bankers, disciplined business development and prudent execution aligned with a pragmatic risk management architecture continues to be the best game plan.
In closing, attached please find our monthly summary of Michigan’s financial institutions. As you and your Board take your organization forward, please do not hesitate to reach out to me and/or my colleagues at ProBank Austin if we can be of any assistance in helping you assess the competitive landscape. Best wishes for continued success in 2018!October 2018 Michigan Banking Summary
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