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Repercussions of the Fed Rate Increase

December 20, 2018
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In a not unexpected development, the Federal Reserve raised short term interest rates again at its Wednesday meeting this week.  This is the ninth rate hike since December 2015, and the fourth in 2018.  At the meeting, the Federal Reserve also indicated that the pace of rate increases is likely to slow in 2019.  What this means exactly is not certain, but the likelihood of four or even three rate increases in 2019 is not high.  In fact, 11 of 17 officials expect no more than two rate increases next year.

What are the implications, not only of the rate increases, but of the central bank’s telegraphing of 2019 actions?  In a word, the Fed sees a softening economy in 2019.  While second and third quarter GDP growth was very strong, especially by recent standards, fourth quarter growth is likely to be less robust, and the concern is that lackluster growth will continue into 2019. 

Is recession around the corner?  A recent survey of corporate CFOs indicated that half expect a recession in 2019.  What are the reasons to believe that a recession is coming?

First, a recession is always coming; it’s just a matter of when.  This current recovery began in June 2009 and is 114 months long.  It is now the second longest recovery in U.S. economic history, and the odds are very strong that it will surpass the longest recovery in history, 120 months (March 1991 to March 2001).  The very modest growth rate in this recovery (2.2% annualized growth per year) is one reason that this recovery has had such a long duration. When growth is slow we don’t have the same degree of over-heating which can lead to recession; for example, we have not seen wage increases or general inflation to any significant degree during this recovery.

There are a few economic indicators that are closely followed which tend to lead to the belief that a recession is not far off.  First is the shape of the yield curve, shown below as the difference between the two year and ten year Treasury rates.  In the chart, when the value is negative, two-year treasury rates exceed 10 year treasury rates; the yield curve is inverted.  Every recession since the 1970s has been preceded by an inversion of the yield by an average of 17 months; the shortest period being 11 months and the longest 23 months. 

Currently, the spread between the two and 10 year treasury rates is hovering in the 15 basis point range – but this is prior to the Fed’s most recent rate action.  If two year yields rise faster than 10 years yields, then we could be moving towards inversion.  When that happens, it seems that it is only a matter of time before a recession begins.

Another factor which tends to be a predictor of recession is initial claims for unemployment, illustrated in the chart below.  As the chart shows, recessions tend to be preceded by several months by an increase in initial claims for unemployment.  While there has been a slight uptick in this data point since its nadir in September, these data remain very low by historical standards. 

Other factors seemingly don’t point to recession; private domestic investment remains strong and unemployment continues to be low.

However, we cannot discount the notion of the “animal spirits”, a useful term coined by John Maynard Keynes.  How we feel about things influences how we act, and with the Dow Industrial average down by over 4% in 2018 the animal spirits of the average investor have probably been deflated, at least to some extent.  We feel less wealthy and are likely to act accordingly.  The same is true of businesses.

Add one last factor: the economic activity of the rest of the world and our economic policies.  Much of the rest of the world is in recession or experiencing low growth.  At some point this infects our economy.  Moreover, trade policies (i.e. tariffs) have added a degree of uncertainty to the outlook.

All in all, it is fair to assume that 2019 will be a year of slower economic growth if not recession, although if recession hits it likely will occur late in the year.  And while the ”R” word strikes fear in the heart of the average person, especially following the recession of 2008-2009, the next recession is not likely to be nearly as severe.  Since 1945 the average recession has had duration of 11 months, much shorter than the 18 month duration of the most recent recession. And as the accompanying chart illustrates, most recessions do not produce the degree of contraction that we experienced in the most recent recession. The last time we experienced a recession as long and deep at the last one was in the early 1980s.

The coming recession is not likely to mirror the 2008-2009 recession for several reasons.

  • Real estate markets are fundamentally sound.  Unlike 2008-2009, the increase in real estate values is supported by real demand (i.e. Millennials) not artificial demand created by sub-prime lending.
  • Our demography is better.  The United States is virtually the only first-tier economy in the world that has a sufficient population of young individuals (Millennials and Gen Z).  Millennials in particular are moving into their prime economic years, buying homes and cars and raising families, and this will continue to support economic growth. 

Should We Be Preparing for Recession?

All the preceding analysis suggests recession will be here sooner rather than later.  It is possible that a recession could emerge in late 2019, although our assessment is that 2020 is a more likely bet.  However, the chances are good that 2019 will exhibit slower economic growth even if a recession does not appear. 

Now is the time to prepare your financial institution for recession.  Below are the critical steps you can begin to put in place today to be better prepared for a slowdown in economic activity or a recession.

  1. Assess the risk in your loan portfolios and put the appropriate guardrails in place.  Loan portfolios are often like consumer investment portfolios; the longer the bull run, the more out-of-sync they get.  Now is the time to rebalance your loan portfolios.  Have you built too much exposure in any area?  Have you become too reliant on any one channel for growth?  Organizations that have built a heavy reliance on indirect lending are in a potentially dangerous position when a slowdown or recession hits, as these portfolios often see the most rapid escalation of delinquencies. 
  2. Now may be the perfect time to accelerate the work you should be doing for CECL.  For those not familiar with this acronym, CECL stands for Current Expected Credit Loss and is the new set of regulations that are being implemented by banks and credit unions to reserve for expected loan losses.  CECL can be looked at simply as a compliance issue, but the data you’re generating to meet CECL requirements can help you fine-tune your loan portfolios and to identify previously unknown areas of risk.
  3. Identify products and services that will be useful to consumers and businesses in recessionary periods and update them as appropriate.  A prime example: skip-a-pay promotions.  These types of services tend to be very well received when the consumer is under a little more financial duress. 
  4. Dust off your loan refinance promotional campaigns.  This may seem like an odd suggestion given that the Fed just raised rates again (and is telegraphing potentially more increases in 2019), but part of the reason the Fed raises rates is so that they can lower them again in the next recession.  Be ready to launch these types of promotions as soon as rates begin to fall. 
  5. Reg-E opt-in.  When Reg E rules regarding overdraft opt-in requirements were first implemented in 2010, many institutions were achieving a 90% opt-in rate with new checking accounts.  Today, most institutions would be happy with 40%.  More often than not, the reason opt-in rates have fallen is due to the fact that we no longer ask the question when new accounts are opened.  Overdraft protection remains a valued service for many consumers, and the likelihood of use will increase in recession. Put processes and measurement in place to improve the opt-in rate for your checking accounts.
  6. Avoid long-term CD promotions.  Many financial institutions paid a severe price in the last recession when prior to the recession they attracted long-term money in CDs at above market rates.  They had to continue paying these high rates even as loan rates fell dramatically.  The need for deposits is becoming increasingly apparent in the industry, and we are likely to see deposit wars emerge in 2019.  You may be involved in these wars; engage in these wars with a longer view.  What this means is that much of your focus should be on core deposits and products where you have the ability to manage rates down, such as money market accounts.  If CD promotions are necessary to attract the required growth, make sure you don’t extend the CD terms too far into the future.
  7. Avoid unnecessary hires.  We often have a tendency to get most expansive in our thinking just prior to a downturn. There is little that is more difficult than having to let people go, especially if you have just hired them.  Make sure that the hires you put in place in 2019 are in areas that will be sustainable long term for your organization.
  8. Prepare your customers for recession. This is not to suggest that you start talking about the “imminent recession.”  Rather, conversation that centers on how long this current recovery is and why we are experiencing the softness in the stock market can be a useful way to begin this dialogue. As humans, we are prone to believe that the last thing we experienced is what we will experience the next time around, and the last recession was particularly severe, so your customers will be fearful. A little history on the fact that recessions happen with some degree of regularity and that few are as bad as what we experienced in 2008-2009 will go a long way to lessening their fears.     

Practical tips will put you in good stead with your customers.  Here are four things your customers should do to prepare for a slowdown or recession:

  • Reduce their debt levels (and refinance loans at other lenders with you)
  • Save more – do they have a six month emergency fund?
  • For those with investments, rebalance their portfolios
  • For those with investments, prepare to take advantage of the opportunities that will arise

It has been 11 years since the onset of the previous recession, and indications are that the next recession is closer rather than further away.  Take some time to prepare your organization for this, regardless of whether it happens in 2019 (less likely) or 2020 (more likely).