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Fixed Income Strategy
By Gray Bowles, FHN Financial

Bank Strategy: Better the Devil You Know

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Investors can be forgiven for feeling whiplash over the rapidly changing market narratives of the last few months. As quickly as “higher for longer” arrived, it disappeared in favor of the more palatable “soft landing” and accompanying rate cuts. While it remains too early for either outlook to be proven correct, the most likely near-term path forward consists of more uncertainty with potential for a few more shifts in sentiment while we wait.
The recent rally in fixed-income markets caught many investors off guard, likely including the Federal Reserve. Current expectations of fed funds futures suggest the market is positioned for five to six rate cuts in 2024, beginning as early as the first quarter. One could argue today that a slowing but growing economy with falling inflation could allow the Fed to remove some tightening, but 150bps of cuts closely resembles recessionary risks.
This view has taken 10-year yields down by ~80bps and “un-inverted” several sections of the yield curve over just a few weeks. While the future is always uncertain to varying degrees, the current economic set-up has few historical precedents.
For financial institutions, this backdrop offers both optimism and risks. 2023 was beset with an unexpected liquidity shock, leading to rising costs, compressing margins, and ultimately lower profitability. As bank managers look forward to 2024, it's no surprise that lower interest rates look appealing, but “better the devil you know.”
Balance sheet dynamics are strained, but there are reasons to be proactive. Liquidity in the industry has stabilized, and while funding costs remain elevated, they are likely near their peak. Simultaneously, net interest margins fell sharply but have also likely reached their bottom with a slight uptick in NIM in the third quarter of 2023. Regardless of cost and liquidity pressures, current NIMs still outperform the lows of 2021, underscoring the impact of higher rates on asset-sensitive financial institutions.
Range-bound interest rates could be a positive factor for bank performance. The ability to reprice asset yields higher (for longer) while keeping credit quality issues at bay may give financial institutions the runway they need to grow out of their legacy low-yielding assets and continue to build capital for the eventual cycle turn. Equity markets have picked up on this, with the KBW Regional Bank index rising almost 20% to end the year.
This isn’t without risk. Remember the thin line the market is walking on rate-cut probabilities. Recession risk may not be consensus, but it is lurking. While markets have been trading bank liquidity from earlier this year, credit quality risks will be paramount during a downturn. Not to mention, asset-sensitive balance sheets will realize margin erosion if rates fall before accumulating enough critical mass in higher-yielding assets. The strategy for most financial institutions is clear. Reprice earning assets quickly because there is little control over funding costs. The easiest path is through the securities portfolio. There are several strategies institutions can deploy, but the end result is to add high-quality, high-yielding assets to the balance sheet.
Over the long term, bank managers have one goal: to increase franchise value. This can be done in two ways: increase earnings growth and de-risk the balance sheet. The current environment offers avenues for financial institutions to improve on both objectives. Be wary of the cycle turning too quickly.
Although this information has been obtained from sources which we believe to be reliable, we do not guarantee is accuracy, and it may be incomplete or condensed. This is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. All herein listed securities are subject to availability and change in price. Past performance is not indicative of future results, and changes in any assumptions may have a material effect on projected results. Ratings on all securities are subject to change.
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