Banking Industry Awaits Rate Drop

By Malcolm McDowell Woods

At financial institutions across the state, all eyes remain on the Federal Reserve, waiting to see how quickly and how drastically interest rates move yet this year. While there’s a strong consensus that a rate drop would be beneficial, industry insiders are mostly voicing their hopes that whatever happens comes gently.

At the start of 2024, expectations were that the Federal Reserve would enact a series of interest rate decreases over the course of the year, as long as economic forecasts proved accurate. After the first quarter of the year passed without any rate changes and following a quiet meeting of the Federal Reserve in mid-March, Federal Reserve Bank Chair Jerome Powell said he still expected rate cuts later this year. For now, rates remain high, pushed there through a series of hikes enacted first in response to the economic fallout of the COVID-19 pandemic. Those dizzying jumps, moving the base rate from a low of zero to the current 5.25–5.50%, came fast and furious over a short two-year span, leaving banks a bit shell-shocked and struggling to adapt.

It’s made for rough waters, but analyst Marc Gall, a senior vice president of the Financial Institutions Group at BOK Financial Capital Markets, thinks anyone expecting huge rate cuts anytime soon should temper their expectations.

“The expectation the market has for this year is that the Fed is going to cut interest rates between two to three times, likely towards the second half of the year,” explained Gall. “The outlook has been that the economy is going to start slowing down, that we’re going to start getting closer to a recessionary time, and that’s what’s going to cause the Fed to start dropping the interest rate.” The challenge for the banking industry, said Gall, is that everyone is left waiting for something to happen.

And waiting. “What a ride,” is how Nicolet National Bank CFO Phil Moore jokingly described the past couple of years. As a bank catering to commercial and industrial customers, Nicolet’s portfolio contains many fixed-rate, short-duration loans that couldn’t be adjusted when rates rose so dramatically. Nicolet has managed to emerge unscathed, but it wasn’t much fun, said Moore. The volatility is tough to manage, he said. “It’s not impossible — we dealt with the ups — but it’s just that much more challenging, there’s more financial risk.”

However, the nature of Nicolet’s lending portfolio — short, two-to-three-and-a-half-year duration loans, works in the bank’s favor, according to Moore. “You know, you hold your nose for three and a half years. It doesn’t feel like too much risk at this point in time, and we feel very comfortable managing that.”

What does Moore anticipate happening over the remainder of the year? “I don’t know, and ask me again in two weeks and I still won’t know,” he laughed. “It’s been crazy right. The market and the Fed have certainly not been reconciled with their thinking, though it seems to me that at least they are getting closer to being reconciled. But what a painful ride it has been, because of the severity and the steepness of the 500-basis-point jump that we just lived through.”

At Peoples State Bank in Wausau, CFO and Senior Vice President Jessica Barnes admits that the rapid and steep rate hikes were challenging. “For someone in my position,” she said, “it’s kind of been fun and exciting in a sick way, but definitely challenging. [Those] very rapid rate jumps were just something I’d never seen before in my career. It was hard to adjust to and make sure we’re still serving our customers adequately.”

The swift hikes reduced the value of investment portfolios at most banks, raising concerns about liquidity.

“It’s funny, because when banks have liquidity and funds available to invest, it’s not as good a time to invest because rates are usually low,” said Barnes. “But when rates are very high, like they are today — and I do believe that we’re at our peak — cash is not as abundant to invest.” Her bank’s approach has been to consciously diversify the structure of its portfolio, so it will perform well in different environments. The bank will also seek opportunities to sell some of its lower-yielding securities that have longer durations for higher yields to help with profitability.

That strategy reveals Barnes’ belief that significant interest rate cuts are unlikely in the near future. “If I believed they were going to be lowered very soon, you could make a case that we could just sit on those larger unrealized losses” for the short term. But Barnes isn’t holding her breath. “We’ve held the view since last year that there wouldn’t be as many rate cuts as were being predicted. When we put together our 2024 plan, we didn’t factor in any rate cuts. And so far that’s been a pretty correct assumption.”

At the Bank of Wisconsin Dells, Senior Vice President and CFO Tracey Pierce is in agreement that any rate cut yet this year will be minimal and later in the year.” I think the curve will somewhat normalize through a series of rate cuts, but at a slow pace for now,” she said. “Probably looking at the fourth quarter, something like 25 basis points.”

That would help most banks, hers included, but only incrementally.

“The perception among some bankers is that all we need is for the Fed to start cutting rates and everything will be okay,” noted Gall, but he doesn’t see banks deriving much cost savings on the deposit side from what he thinks will be small cuts. “Really, the Fed needs to cut a lot in order for things to get materially better on the margin side in the short term. And again, if the Fed starts cutting rates, that’s incrementally beneficial over the long term, but most of them need a big drop quickly, which is not what the outlook is for this year.”

That means the potential for continuing squeezed margins and questions of liquidity, issues that came to the fore last year after several bank failures across the country. Gall and others say it has resulted in an increased scrutiny on liquidity from bank regulators.

“Liquidity really is the biggest concern for our industry right now,” said Pierce, of the Bank of Wisconsin Dells.” We’re starting to see the effects of inflation on our deposits.” Inflation has forced consumers to spend excess savings, leaving banks with fewer funding sources.

Gall added that the volatility of the past several years has impacted banks across the state differently. “There are some banks right now that have very good earnings that have enjoyed even higher earnings as interest rates have risen, but there are others that have seen their earnings drop significantly. It means the range of performance between Wisconsin banks is the widest it has been in a very long time.”

Finally, muddying the waters is the looming shadow of the presidential election in November. Traditionally, the Fed has preferred to avoid making significant policy moves near the election, lest it be accused of interfering with politics, but no one knows for sure what will happen. “So that’s a wild card, right?” said Moore.

Just what the banking industry doesn’t need — more uncertainty.

“It’s my greatest fear,” concluded Moore. “It’s just so much more challenging to manage. I’m just hoping for consistency and stability.” He’s not alone.

McDowell Woods is a freelance writer and an instructor of journalism and media studies at the University of Wisconsin–Milwaukee.