December 2024 – A Kind of Hawkish December Rate Cut – the Federal Reserve’s White Elephant Gift to Banks and Markets
A white elephant holiday gift exchange is where friends trade impractical gifts that may not be useful and can be difficult to get rid of. At the December FOMC meeting, the Federal Reserve gave banks and the market a white elephant gift – specifically a rate cut and voted 11-1 to lower the Fed funds rate by 25 bps to a range of 4.25% to 4.50%. Like a white elephant gift, this rate cut was one that the US economy and bond market did not need, but the Fed decided to bestow anyway, ostensibly because US interest rate futures had priced it in.[1] By contrast, a simple Taylor rule would have suggested the Fed funds rate should be turning up, not down in H2 2024.
At the same time, more wanna-be FOMC dissenters signaled their discomfort with further Fed rate cuts in 2025 through their forecasts for inflation and the long-run neutral rate in the December Summary of Economic Projections, prompting Chair Powell at the press conference to describe the December decision as “a close call.” [2] So the December FOMC meeting became an awkward white elephant gift where the Fed delivered on December meeting expectations even as Chair Powell signaled growing potential for a change in Fed policy direction in 2025.
[1] I have written about previously in my Substack how central banks face the problem when looking at market pricing of whether it reflects what markets expect them to do or what markets think they should do.
[2] Congratulations to President Hammack on her dissent at the December FOMC meeting.
Once again the 10-year Treasury yield rose notably, rising more than 10 bps to above 4.50%, following the Fed’s decision. The 10-year Treasury yield is now up ~90 bps since the FOMC began to ease interest rates in September. Some may argue that this move was due to changed policy expectations for 2025, but frankly this kind of price action is what happens when the central bank has misjudged and shouldn’t be cutting interest rates.
The big miss for many, including the Fed, in analyzing economic developments continues to be fiscal policy. As noted in this column back in September, government spending increased in Q3, headed into the US election. Since the FOMC began cutting interest rates, the US budget deficit (white line) widened from -5.4% of GDP in August to -7.1% of GDP in October.
Even as the budget deficit widened substantially, the FOMC cut rates by 100 bps (yellow line) and, unsurprisingly, core personal consumption expenditure which had not yet come back to the Fed’s target began to rise again. Further, there is risk that the US budget deficit expands still further in Q4 due to the current administration pushing out current spending priorities ahead of the January 20th US presidential transition.
Given the combination of both fiscal and monetary stimulus, US real GDP growth unsurprisingly is accelerating. The Atlanta Fed’s GDPNow measure suggests US Q4 real GDP growth is likely to clock in above 3% q/q vs 2.8% q/q in Q3. Per the Congressional Budget Office, the US economy continues to grow about a full percentage point above its estimated potential.
Strong US growth is envied and has resulted in strong foreign capital inflows into US assets. Fed policy currently is not restrictive as US financial conditions remain highly accommodative. US corporate bond spreads are extremely tight given limited defaults and US equity market valuations are high.
Overarchingly, the Federal Reserve kicking off a rate cut cycle in Q3 was a bad idea. FOMC members didn’t seem to expect fiscal policy to ease into the 2024 election. A new Fed policy misstep is now broadly evident to most market observers, except perhaps to most of the FOMC.
Even leaving aside plausible inflation risks related to the new policies from the Trump administration on immigration and China tariffs in 2025, some in the Treasury market may perceive the potential for a concerning parallel to the 1970s when both fiscal and monetary policy eased after the first inflation shock and inflation then resurged. Depending on fiscal, immigration and tariffs, a possible scenario is that the Fed actually may need to raise rates in 2025. Sound outlandish? Adam Posen of the Peterson Institute raised a 2025 Fed rate hike scenario in May 2024.
So as we end 2024, US banks are in an awkward situation due to the Fed’s December white elephant gift. US bank stocks have rallied materially – even more than after President Trump was first elected in 2016 — largely on two factors related to profitability:
- expectations of a Fed rate cut cycle significantly dis-inverting the Treasury curve and assisting banks with low yielding assets to improve profitability.
- expectations of deregulation/de-supervision that is expected to be positive for bank profits.
Factor #1 – the market now understands that lower interest rates in 2025 are more uncertain.
Fiscal stimulus will accelerate into the mid-January US presidential transition. Ironically, a fiscal downshift in late Q1 2025 could produce an air-pocket when the Biden administration’s last burst of fiscal spending is over. But an inventory build from US businesses in anticipation of tariffs could help offset this effect. So although it does not look to be a base case right now, in early 2025 there is some chance that fiscal policy will tighten due to the transition. This seems to be the best hope for permitting some further Fed rate cuts.
That said, administrations of both US political parties have shown a willingness to continue to use deficit spending to juice the economy. The 2017 expiring tax cuts will be extended, likely funded by quasi-permanent China tariffs. Of course, the extension of these tax provisions doesn’t ease fiscal policy. However, new tax cuts related to overtime pay and tips were floated during the campaign and lower income workers were important to President Trump’s re-election. These measures would likely come to Congress in H2 2025. Will there be pay-fors/offsets for these tax cuts? At this time, there does not appear to be a consensus among President Trump’s advisors on tightening the US fiscal policy stance – so I would not count on tighter fiscal policy creating the policy space for Fed rate cuts in an enduring way in 2025. Immigration policy and tariffs also both pose upside risks to inflation — magnitude and timing of these policy changes are uncertain.
Current bank profitability is weak, but, after the election, investors anticipated bank profitability to strongly improve due to lower interest rates. With the change in the rate outlook, the profitability outlook for US banks is less certain than some investors may have believed.
To quote the November 2024 FOMC minutes, “[r]egulatory capital ratios in the banking sector remained high; however, banks continued to hold large quantities of long-duration assets, leaving them more exposed than usual to an unexpected rise in longer-term interest rates.”
Following yesterday’s December FOMC meeting, the S&P-500 regional bank index ended the day down 5%, underperforming the S&P-500 which declined 2.95%. As boring as this story may feel as we prepare to head into 2025, long duration assets have an annoying way of hanging around bank balance sheets.
Will developments in US interest rates and how some banks manage this environment of elevated interest rate volatility lead to banking sector volatility again? I do worry about this. It is key to remember that monetary and fiscal policy errors kicked off the US regional banking crisis in 2023. Unfortunately, further missteps with these macroeconomic policies in 2025 could continue to affect banks through higher for longer interest rates and also potential liquidity strains in H2 2025 given the ongoing shrinkage of the Fed’s balance sheet which can reduce both US banking sector liquidity and withdraws deposit funding.
At the December meeting, the FOMC decided to maintain its current pace of ongoing shrinkage of the Fed’s balance sheet – otherwise known as quantitative tightening (QT). But it also lowered the rate paid to money funds on the Fed’s overnight reverse repurchase facility (ON RRP) by an additional 5 bps to squeeze extra cash out of that facility and keep more central reserves in the banking system. US banking system reserves at the Fed were approximately $3 trillion when SVB failed in March of 2023 (red line), the shrinkage of the Fed’s balance sheet has largely come through a decline in ON RRP but that is getting tapped out with only $131 billion left in ON RRP balances. As of 12/11 there is about $3.2 trillion in US bank reserve balances at the Fed, so roughly $200 billion more than when SVB failed.
The FOMC’s ONRRP rate cut was smart given that money funds might try to switch to holding more reserves at the Fed as opposed to T-bills in an environment where there is some positive probability of policy rates moving higher in 2025. However, if potential Fed rate hikes do become more of a concern in 2025, reserve balances at US banks still could feel pressure if money funds sought to move back into zero duration Fed balances. A 5 bps cut by itself might not be enough.
That said, Treasury debt limit is approaching in early January which means the Treasury will reduce its cash holdings at the Fed to minimize debt issuance until Congress raises the debt limit. A decline in Treasury balances at the Fed will increase reserve balances at banks, reduce risks to banks from any surprise ON RRP growth, and inject liquidity (and maybe even froth) into financial markets in early 2025.
On balance, QT seems fine for now but still has its risks for banks. The Fed only directly controls the aggregate size of its balance sheet and merely can seek to influence the distribution of its liabilities between ON RRP and reserves held by banks.
Since SVB’s failure, some US banks have sold modest amounts of equity or sold their fee producing businesses to offset prior interest rate losses and clean up their balance sheet. While it is important that they reduced their holdings of low yielding assets to improve profitability, banks still will need to do better in managing their ALM going forward in 2025. Some US bank teams have really improved, but other teams still need to upgrade their treasury, ALCO or board’s abilities to navigate this changed environment of more interest rate and liquidity risk [pro-tip – consider BTRM’s April enrollment!]. Inflation and interest rates were supposed to come down nicely in tandem – but that isn’t what is happening.
CRE is the greatest area of near-term credit risk for US banks. A higher 10-year Treasury yield is a headwind for long-dated assets — like commercial real estate — that increasingly need refinancing of pandemic era loans at now much higher interest rates. As the next series of charts show, the share of hospitality, industrial warehouse, and office CRE loans in CMBS securitizations on the watchlist exceeds 25% in most US MSAs.
It is true that some bank CRE loans can have better risk characteristics than loans in CMBS securitizations – most notably related to CRE borrower recourse/personal/sponsor guarantees. However, it still should be recognized that the repricing of the 10-year Treasury will negatively affect banks’ CRE too. Such a deterioration will either come through weaker CRE loan performance or lower bank profitability as a result of overly favorable loan pricing/extend and pretend, as was recently highlighted in a paper by staff at FRBNY.
Factor #2 – deregulation currently seems a bit lacking in constructive policy content. The Trump administration has yet to discuss much in terms of changes to bank regulation that reduce burden without increasing safety and soundness risks – yet hopes for bank profitability improvement are high. De-supervision can be costly both for specific banks and the sector due to contagion risk– as SVB and First Republic’s failure illustrated. For example, I get concerned when supervisory findings related to operational risk/cyber are described as excessive or otherwise downplayed in their importance.
Constructive regulatory change that improves the US banking sector’s profitability is possible. For example, last week I proposed consolidation of the four US federal supervisors into a single federal supervisor to reduce cost and burden to banks while increasing bank supervisory efficiency and accountability.
However, if in fact US bank supervision and regulation is weakened without a concomitant change in US crisis response to bank failures, it implies future bank failures that may increase the government debt stock. This result may cause those banks and policymakers who didn’t work in banking during 2008 to relearn some of those painful bank crisis lessons.
As the year comes to a close, I am grateful for the opportunity to share reflections with Cetina’s Bank Treasury Talk readers. I hope these reflections are helpful and I wish you all a healthy and happy holiday season surrounded by family and friends!
