By Michael Gerbick; President, Young & Associates
On Wednesday, January 29, 2025, Jerome Powell and the Federal Open Market Committee (FOMC) decided to maintain the target range for the federal funds rate at 4.25 – 4.50 percent after three successive cuts totaling 100 bps in September, November, and December. There continues to be heightened attention and focus on the yield curve, and for valid reasons, as the curve’s shift has been dramatic in recent years.
The chart below shows the yield curve at five different points in time from January 2022 to Tuesday, February 18, 2025. The shape of the curve has gone from normal to inverted and now back to normal. Looking at a few different US Treasury Bond maturities over the last 14 months, you can see the one month yield has decreased over 120 bps and the 20 year has increased over 60 bps! Each rate curve shape and elevation imply different opportunities for your balance sheet. A more asset-sensitive and positive gap on a balance sheet may be more attractive for earnings in the short term and helpful when the Fed was raising rates in 2022 and 2023. A more liability-sensitive and negative gap on a balance sheet may be more attractive for earnings in the short term as the Fed reduces rates. Your ALCO is likely well-versed in these shifts and has been managing these drastic movements and their impact on the Bank’s overall strategy.
The normal yield curve indicates improved expectations for economic growth in the years ahead. That said, there is also caution for inflation. When the Fed began rate reductions, there were discussions regarding more cuts totaling 100 bps by year end 2025, then these ambitious views have shortened to perhaps two cuts of 25 bps each. The yield curve is still elevated from what it was several years ago and the Fed Funds rate is higher than the previous cycle’s peak of 2.25 – 2.50 percent in 2018-2019. The consumer is more savvy than they were at that time as well.
At the end of 2024, we spent time interviewing some of our community banker colleagues to gain a pulse on what they are talking internally about in their ALCO meetings concerning interest rate risk. As expected, there is an overall sense of relief to have a normal yield curve instead having to manage to the inverted one of recent years. There is still an overall sense of caution headed into 2025 for many reasons, with two key factors briefly discussed in the following sections.
Cost of Deposits
Community banks may not realize the full impact of the Fed’s rate reduction in their cost of deposits. Given the continued elevated competition for deposits and the more savvy consumer, community banks may find their deposit rate offering slower to adjust than the Fed’s rate movements and some may see their interest expense actually increase in 2025. There may also be migration to more longer term duration CDs (movement from less than 6 months to 1 year or more). Yes, longer term CDs will keep the deposit costs higher than non-maturity but will create welcomed funding stability for the bank. Continued focus on the bank’s deposit makeup and shifts are necessary. Staggering the CD maturities will be critical for community banks to manage this new environment so as to maintain adequate liquidity levels as CDs mature and consumers make a choice to reinvest, migrate to shorter term or perhaps withdraw their funds.
Investments
Many investments were made by community banks with PPP funds and other excess liquidity in a low rate environment back in 2021. The Fed raised rates 550 bps and many of those investments contributed to a significant amount of unrealized loss. Now, the Fed cut rates 100 bps and the yield curve is no longer inverted. The rates are still elevated and there are still a significant amount of investments on community banks’ balance sheets with unrealized losses. The chart below shows the fair value of investment portfolio expressed as a percent of the amortized cost of the investment portfolio over the last four years for commercial banks.
You can see all three asset sizes over the last four years have a similar trend line. Consider a bank having $100MM in their security portfolio, it is likely its portfolio is currently $7-$10MM underwater. This changes each day as these investments continue to reprice and mature over time. As they do, bank management is faced with how best to serve its bank either in reinvesting short-term or long-term within their investment portfolio or funding higher yielding loan growth opportunities. Each has liquidity and capital implications that must be considered.
Conclusion
Community banking is resilient and the conversations with community bankers reveal their drive to prepare and plans for managing risk in 2025 and beyond. ALCO and Boards of Directors should continue their sharp focus on managing interest rate risk. If the deposit competition is fierce for your Bank and interest expense in 2025 is expected to be elevated, then focus on what is within your bank’s control. On the asset side of the balance sheet, consider paying attention to the loan and investment portfolios and when they are repricing, what additional loan fee income can be generated, revisiting discussions and confirming the types of loans the bank is comfortable making.
When considering interest rate risk, confirm your bank’s risk profile and always remember to stay within the Board approved risk parameters. Your bank’s balance sheet may have experienced significant change away from a neutral risk position given the economic environment in recent years. If you have found your bank is outside the risk parameters, discuss strategies with your Board that are designed to get the bank back within acceptable risk thresholds. Always be clear with the Board on expectations and inform them we may not be able to fix this overnight. One banker said it best when providing advice for community bankers trying manage the interest rate risk of the bank, “Always manage the bank’s IRR to a better position, even if getting to that position takes years …don’t get ahead of your skis and try to do it all in one day.”
Lastly, thank you to those community bankers that spent their time discussion IRR and sharing their insights in the interest of helping other community bankers.
If you’d like to hear more about our ALM services, specifically interest rate risk and liquidity risk reviews, please reach out as we would be happy to discuss and assist.
