Page 30 - October 24, 2024 Bulletin

BUSINESS PARTNERfeature article

The Fed Finally Cut Rates –

Now What?

Ryan W. Hayhurst
President
The Baker Group

After the most aggressive tightening cycle in forty years and the bond yields have already fallen enough and will not fall further.
second longest period ever with rates at the peak of the cycle, the History suggests this may not be the case. During each of the
Federal Reserve finally relented and cut rates 50bp in September. last five easing cycles in 1984, 1989, 2000, 2007, and 2019,
And just like that, the banking industry has pivoted from bond yields actually fell more after the first rate cut than before.
focusing on the risk of rising rates to the risk of falling rates. For If you average the moves during those five easing cycles, the 2yr
the last three years, banks have been managing the interest rate yield fell an average of 141bp prior to the first rate cut but fell
risk associated with rising rates. Deposit costs have surged, bond an additional 405bp after the first rate cut. The 10yr yield fell an
portfolios have depreciated by record amounts, and margins average of 126bp before the first rate cut and then fell a further
have been squeezed. Now that the Fed has cut rates for the first 308bp after. This suggests bond yields may have much further
time since early 2020, what should community banks expect to fall during this easing cycle, and banks should prepare their
during this easing cycle and how can they better prepare for investment portfolios and balance sheets for lower rates in the
lower rates? years ahead.

Fed Funds Rate & Prime Bond Portfolio

The Fed’s September “Dot Pot” showed they expect to cut Bank bond portfolios depreciated significantly as the Fed hiked
rates another 50bp in 2024, followed by 100bp in 2025 and a rates aggressively in 2022-23 and remain at an unrealized loss
final 50bp in early 2026 to end with a fed funds rate of 2.75- despite the recent drop in rates. And banks have purchased
3% and a prime rate of 6%. This means banks should prepare far fewer bonds in the last twelve to eighteen months with
for short-term interest rates to fall about 200bp over the next yields near 5% than they did in 2020-21 when yields were
eighteen months if the Fed’s forecast is correct. However, the near record low levels. In fact, some banks have not purchased
Fed’s “Dot Plot” is based on their forecast for a “soft landing.” a bond in the last two years. This means those banks will not
What happens if a recession occurs in 2025? Then the Fed will have any unrealized gains in the portfolio that they could use
almost certainly have to cut rates more than that and much more to offset potential loan losses, which may occur if the economy
quickly, probably pushing the fed funds rate below 2% in 2025 enters recession in 2025 or beyond. Banks should be actively
if history is any guide. participating in this market by adding bonds to the portfolio
while yields remain higher than in sixteen out of the last
Bond Yields seventeen years.

Bond yields normally lead the Fed lower and typically fall in All banks should maintain a written investment strategy to
anticipation of future rate cuts. Prior to the Fed’s September help manage risk and maximize performance. This strategy
rate cut, the 2yr Treasury yield had already fallen 160bp and the should be focused on preparing the portfolio for an extended
10yr yield had fallen about 140bp. Some bankers may believe

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