What #Banking Trend Will Have the Greatest Impact on Your Bank?

This was the question posed to Bank Profitability students as part of the Oregon Bankers' Association's Executive Development Program (EDP). These were up-and-coming bankers, the future leaders of our industry, identifying industry trends that will have the greatest impact on their bank, in no particular order. 

1. Interest Rates

So many financial institutions had a positive GAP (assets that are maturing or repricing within one year minus liabilities that are maturing or repricing within one year) during the Fed's ambitions five quarter rate hike from zero to 5.25%, meaning that they were asset sensitive and their net interest margins should have expanded. And then what happened in 2004-06 happened again. Depositors woke up and thought "what is my bank paying me?" And our cost of funds chart looked like the trail lift at Breckenridge. The Fed has paused for nearly a year now, and it was our experience in 2006-07 that bank cost of funds continued to increase as the market closed the delta between what someone could earn in a money market mutual fund and a bank account. Cost of funds is leveling off now. But not until $1 trillion went from banking to money markets. Will NIM compression continue, as it did last year (see chart from American Banker)? Will bankers reposition their balance sheet to be liability sensitive so NIMs will improve with falling rates? And will their ALCO reports accurately predict what will happen? Time will tell and it is weighing heavily on bankers' minds as the most impactful to their banks' success. And with our industry still heavily dependent on net interest income for revenue, I think they are right.

2. Consumer Demographics and Changing Customer Demands

Remember all the pre-pandemic talk about millennials? You couldn't go to a conference without every presenter having millennial this or millennial that on their slide decks. They are digital native, meaning they never knew life without the Internet. We've been able to ignore them because, well, they didn't have big borrowing needs nor did they have any money in their deposit accounts. Besides what was needed to buy some Keystone Light and Vlad for this weekend's party. Now the oldest millennial is 43 (see table by Statista). They have cars, houses, and are nearing their peak earning years. They are starting businesses and inheriting money from The Greatest Generation and Baby Boomers. In other words, great bank clients with high lifetime values. In fact, there are segments of millennials that have always had high lifetime values. That's why Sofi went after them at the end of college, focusing on the engineering majors and leaving the English majors to others. High lifetime value. Now we have to tailor what we do, how we do it, and how we differentiate to these young whippersnappers that never had to scroll through library microfilm when researching a college paper. Our tortoise approach worked when Baby Boomers controlled the wealth. EDP students fear it will work no longer. 

3. Shadow Banking

This trend seemed very specific to current commercial lender anxiety today. Because of our current liquidity situation, where depositors now carry lower average balances per account, the aforementioned trillion that went to money market accounts, and our bond portfolios being underwater, nearly every banker is hunting for deposits. As part of that full-court press, commercial lenders are being asked for higher and stricter compensating balances from borrowers. Experienced borrowers are feeling the pinch from the multiple banks they deal with. And, according to some EDP students that are lenders, are turning to the shadow banking market that do not have deposit demands. Such as direct lending funds, and insurance companies. Shadow Banking refers to banking-like operations that take place outside of the mainstream banking industry. Shadow bank lending is similar to bank lending but is not subject to the same regulations, and compensating deposit balace requirements. Typical shadow banking entities are bond funds, money market funds, finance companies, and special purpose entities. Business Research Insights estimates the worldwide shadow banking system to be over $53 trillion in 2021 and believes it will grow to $85 trillion by 2031, a 5% compound annual growth rate (see table). Although shadow banking mostly serves larger corporations, think money market funds buying commercial paper, bankers fear the trend will continue going downstream to more traditional community bank customers.

4. Commercial Real Estate Uncertainty/Vacancy Rates

Nineteen point six percent of office space is vacant at year end 2023, according to Axios.com (see chart). Vacancy reached a record high in the fourth quarter and surpassed previous peaks last reached in 1992. Office buildings are emptying around the U.S., as companies continue to adapt to the new norms of remote and hybrid work by shrinking their real estate footprint. Although large office towers in big cities are not usually part of a community financial institution loan portfolio, smaller commercial real estate in urban areas and throughout suburbia and rural markets are. Commercial rents are projected to decrease by a small amount this year, while borrowing costs will escalate as those that borrowed in the low interest rate environment of 2017-19 have their loans coming due, some at twice the rates of their maturing loan, putting pressure on debt service coverage ratios. Rents are lower, borrowing costs are higher. Do bankers make exceptions to policy, ask borrowers to kick in more equity, or push borrowers out of their bank? There's better news for multi-family and warehouse lenders, as these sectors of CRE are doing just fine. But bankers should be preparing for a devaluation of the collateral used by their borrowers to determine how best to manage this emerging situation.

5. Regulation and the Political Environment

"Last month, the CFPB reported how banks have become more dependent on these fees to feed their profit model on checking accounts. In 2019, bank revenue from overdraft and non-sufficient funds fees surpassed $15 billion with the average cost of each charge between $30 to $35. But that's not the only product where large financial institutions feast on their customers through fees. In 2019, the major credit card companies charged over $14 billion each year in late fees with an average charge of around $35. And when buying a home, there's a whole host of fees tacked on at closing where borrowers feel gouged."

~ Rohit Chopra, CFPB Director, January 26, 2022

"I am pleased to support this adoption (of required climate disclosures) because it benefits investors and issuers alike. It would provide investors with consistent, comparable, decision-useful information, and issuers with clear reporting requirements."

~ Gary Genslar, SEC Chairman, March 6, 2024

"The CFPB and other regulatory bodies will use the disclosures required by Rule 1071 of the Dodd-Frank Act as a cudgel to pressure bankers to lend to politically favored small businesses or to not lend to politically disfavored small businesses."

~ Jeff Marsico

6. Technology Advancement and Generative Artificial Intelligence

In the third quarter of 2023, the total operating expense to operate a branch was 47% direct cost: branch salaries and benefits, lease expense, etc. and 53% indirect costs: operations, IT, human resources, etc. This is a hefty burden to put on a branch that is competing with branchless banks that don't incur the direct costs and can pass that on to depositors in the form of higher interest rates. Bankers must get serious about driving down the cost of the pistons, carburetors, and batteries of running a bank. Technology offers opportunities to do just that. Additionally, customer acquisition is another significant cost to financial institutions. Technology and Generative AI could dramatically lower those costs. As well as compliance, fraud, credit, reconciliations, reporting, and other risk mitigation that is currently performed in a resource intensive way. The opportunity to lower costs without escalating risks, in fact likely lowering risks, is near. EDP students think this could have a significant impact on their banks. 

7. Branch Consolidation

Community financial institutions are caught in this place where they want to demonstrate commitment to the communities where they operate yet can't figure out how to do it profitably in certain locations. Large financial institutions simply consolidate their branches. Community bankers still consider this as a sign of weakness to the market, lack of commitment to its leaders and residents, and admission to a mistake to enter the market in the first place. This, of course, was a Bank Profitability course, and when staring in the face of hard data, namely a branch's income statement showing perpetual red ink, it becomes more difficult to justify keeping the branch open with those soft reasons such as not supporting the community. I got news for you, if you can't operate a branch profitably and you are satisfied that the reason is not because of poor execution by your bank, perhaps the community doesn't support you.

~ Jeff

How Did Your ALCO Model Hold Up?

My firm did a sample data run for a client that included all commercial banks in NY, NJ, PA, and MD between $500 million and $1.5 billion in total assets to see how various banks did in balance sheet and income statement ratios during the course of the Fed tightening run from year end 2021 until the third quarter 2023. Some interesting insights relating to their 1-year cumulative repricing gap that the banks reported on their call reports:

• At 12/31/21, of the 68 banks that met the criteria, only 10, or 15% had a 1-year cumulative negative gap. This is defined as rate sensitive assets (assets that are expected to mature or reprice within 1 year) less rate sensitive liabilities (liabilities that are expected to mature or reprice within 1 year). If rates went up, so the theory goes, the 85% of banks with a positive 1-yr cumulative gap, should see net interest margin go up as assets reprice faster than liabilities. This made sense because the Fed Funds Rate at this time was 0-25 bps and bankers positioned their balance sheets accordingly.

 

• At 12/31/22, after 450 bps of Fed rate hikes, 48 of the 68 banks, or 71%, had a better net interest margin for the quarter ended 12/31/22 than the quarter ending 12/31/21. Since 85% of them had positive one-year cumulative gaps, their ALCO assumptions mostly worked.

 

• At 9/30/22, only 13 banks, or 19% showed a negative one-year cumulative gap. Meaning 81% thought their net interest margin would increase in a rising rate environment. Between 9/30/22 and 9/30/23, 53 banks, or 78%, had a lower net interest margin. How could their ALCO assumptions be so wrong?

• By 9/30/23, the 1-year negative cumulative gap had nearly tripled to 30, or 44%. Interesting because the Fed Funds Rate was zero-25bps at 12/31/21 and almost everyone knew rates would inevitably go up. It makes sense that so few considered themselves liability sensitive at 12/31/21. I'm actually surprised so few (44%) consider themselves negatively gapped right now. Declining rates are far more likely than rising rates. The most recent Fed dot plot predicts Fed Funds declining in 2024.

When I asked my colleagues what they thought, here is what a couple of them had to say:

If I recall from my ALCO committee days… ALCO models largely did not rate shock 450-500 points and if they did, that type of move seemed quite far out of the realm of possibilities.  In a 200-300 model, spreads would have mostly held up. My guess is that the duration of money market accounts in most ALCO models were in the 3-6 year time frame but when rates went up 500 points in the real world, these longer duration "core deposits" actually left the bank or repriced much faster than anticipated as banks worked to retain these accounts.  Also, many banks were using CDs to retain these accounts and shifting deposits out of these longer duration products into 6-12 month CDs shortened the liability duration averages (in models) and increased the liability sensitive nature of most banks.

Deposit duration assumptions in ALCO models built for 'normal' markets simply did not hold up in recent quarters.

~ Ben Crowley, Managing Director, The Kafafian Group, Inc.

I think bankers overestimated the loyalty of their depositors following the pandemic & PPP, coupled with a sustained low rate/high liquidity environment. These factors led to a false sense of security that low-cost deposits were there to stay. When the national and super regional banks began raising rates they were reluctant to follow – until it was too late. They quickly learned that customers were not loyal and deposit attrition happened so fast that they had to raise rates more aggressively than anticipated to retain remaining deposits and attract funds to replace what they had lost.  

Service is important. But you still have to price competitively.

~ Chris Jacobsen, Managing Director, The Kafafian Group, Inc.

~ Jeff

Guest Post: Financial Markets and Economic Update by Dorothy Jaworski

Winter Squalls

It’s mid-February and I’m watching a snow squall outside, reminding me that it can be bright and sunny one moment and turbulent the next.  As we try to navigate our way through this volatile time in the markets and in the economy, we seem to get surprised almost daily by large moves in the stock markets, already in correction territory, in the bond markets with rapid interest rate increases, in the highest inflation in 40 years, and in the tense situation surrounding Russia and Ukraine.  And I don’t mean to sound downbeat, but the Federal Reserve is about to raise interest rates amid an economy that is already showing cracks.

The economy seems to be slowing, despite glowing reports like the +6.9% growth in real GDP in the fourth quarter, strong payroll growth in January with the unemployment rate at 4%, and inventory building that could be the first step in solving supply chain issues.  In fact, inventories accounted for +5.0% of the +6.9% GDP growth, leaving only +1.9% in real final sales, which is very weak compared to +8% to +9% in the first two quarters of 2021.  Many businesses are seeing labor shortages, as we are still several million payrolls short of where we were in early 2020.  Inflation may be a large culprit in slowing growth as people cut back on discretionary items to be able to afford the necessities of life - food, gas, electricity, etc.

Stock and bond market volatilities are also seeing winter squalls and are sending messages about shifting investor sentiments about risk.  The Fed is about to embark on another tightening campaign and will raise short-term interest rates starting in March and will likely make moves faster than most investors expect.  They will have ended their bond purchase program and will shift in a few months to letting their massive assets (currently close to $9 trillion) begin to run off.  Investors have seen this movie before and are fearful of recession in 2023 or 2024.  Credit spreads have begun to widen.  At the same time as Fed tightening, the fiscal policy of handing out “free money” has apparently ended and the consequential explosion of demand will abate.  They have to stop; our Treasury debt is massive at over $30 trillion.  People know the “free money” and easy Fed policy were certainly not “free” and they are paying the price with inflation.

Interest rates have risen dramatically since the beginning of 2022, with the 2 year Treasury up .76% and the 10 year Treasury up .42%.  With inflation so high, we have negative real yields, which means over time good returns on investment are difficult to attain, so we may see cuts in business investment.  Interest rates also seem distorted compared to equity returns, with the 10 year Treasury at 1.92% and the S&P 500 forward dividend yield at 1.57%.  Shouldn’t these be the other way around?  As rates have risen, the yield curve has flattened, with long-term points of it inverted (20 year and 30 year).  Flat and inverted yield curves are not a good sign before the Fed even raises rates once.

As mentioned earlier, consumer spending likely will slow as excess demand fades.  The old misery index, defined as unemployment plus CPI inflation, tells the story of everyday living.  The index is currently at 11.5% in January (4% plus 7.5%), which is the highest since 10.4% in May, 2012, but not near the all-time high of 22.0% in June, 1980.  Oil is above $90 per barrel and gas prices are above $3.80 per gallon.  Consumers may reach a “tipping point” where they cut spending dramatically because of their anger at energy prices getting too high.

Finally, the index of leading economic indicators fell by -.3% in January, which was the first monthly decline since the beginning of 2021.  It portends slowing growth six to nine months from now.  Fed policy also works with a lag of six to nine months.  The end of 2022 could be very interesting from all angles, including the federal mid-term elections, and may still be full of winter squalls.

 

Real GDP

We just experienced one of our strongest GDP growth quarters, with real GDP at +6.9% in the fourth quarter of 2021.  Inventory building accounted for the vast majority of that growth, or +5.0%.  Real final sales grew only +1.9%, which is weak, and followed only +.1% in the third quarter.  GDP for all of 2021 was +5.7%, following a year of decline in 2020 of -3.4% due to Covid-19 lockdowns.

Too much stimulus from the federal government drove demand too high in 2021.  Nominal GDP was +10.6% in the first quarter and grew to +13.9% in the fourth quarter as consumers shifted to buying goods rather than services, and supplies could not keep up.  We’ve heard all about the supply chain issues - from manufacturing to distribution- from cargo ships to trucking.  The federal stimulus also drove our national debt levels to over $30 trillion, or 123.4% of GDP.  As we learned during the expansionary decade of 2010 to 2020, GDP greater than 90% for several years will lower GDP by one-third.  Growth only averaged +2.2% during that time, albeit with the bonus of low inflation.

Consumer spending, which represents about two-thirds of the economy, is already weakening as excess demand fades.  Consumer confidence is at relatively low levels, mostly attributed to the inflation shock.  Prospects for growth this year are decent at +3.8% GDP and most estimates project lower growth of +2.5% in 2023, which is back to the lower equilibrium growth rate of just over 2%.  Can the Fed carefully engineer the slowing of growth without risking recession?  We shall see how aggressive their tightening campaign is.

 

Inflation

Oh, the monster!  Oh, the misery!  We all hate inflation.  The prices of just about everything that matters to us are rising- food, energy, medical care, housing and rent, new and used cars, electricity, clothing…the list can go on.  The CPI started 2021 at +1.4% to +1.7%, rose to +5.4% by mid-year, and ended December at +7.3%.  January rose again to +7.5%.  Inflation has eroded spending power with real incomes dropping -4% by the end of 2021, even though wages were rising +4.5% year-over-year.  The Fed started out saying inflation was “transitory” but had to admit later it was “persistent.”  Now we will see if the Fed can keep it from becoming “sustained,” with wage inflation from tight labor markets filtering into the prices of all goods and services. 

Inventories of existing homes has been extremely tight, at 1.6 months’ worth of sales in January, driving recent year-over-year prices on homes up +17.5% to +18.5%.  Higher mortgage rates will undoubtedly reduce demand, with 30 year mortgage rates now above 4% reducing affordability.  CoreLogic expects price increases to decline to +3% to +10% during 2022.

We scream at how bad inflation is when it is at its worst.  There are some clues that inflation may stop rising or recede soon, as supply chains get repaired and more goods flow.  We saw inventory building of a huge scale in the fourth quarter, so a surplus of goods, at a time when demand is declining, is not a prescription for higher prices.  Backlogs are declining in a sign that goods orders are being met.  The flood of government stimulus has faded and the declining budget deficit to GDP, from 5% in 2020 to less than 1% now, points to lower inflation in the year ahead.

Productivity has been on the rise, with capital investment in technology and machines, and may serve to keep unit labor costs in check and profit margins stable.  The dollar has been strong, keeping import prices lower than they otherwise would have been.

Inflationary expectations built into the Treasury market show inflation declining over time:  2 years at 3.55%, 5 years at 2.93%, and 10 years at 2.50%.  if the markets thought inflation would be 7% or higher, yields would already be there.  Even Larry Summers, one of our nation’s biggest inflation hawks, thinks CPI will fall back some to 4% this year.

 

Supply Chains and Labor Shortages

They are connected.  The huge increase in demand exposed the flaws in our systems.  Delivery issues, especially from ocean freight and port back-ups, left many manufacturers short of goods to run production lines and store shelves were left bare.  Labor shortages also played a key role.  Spikes in new Covid-19 variants led to record high employee absences.  But workers are still leaving the labor force from the Great Resignation, retirements, child care issues or costs, burnout and work-life balance, or starting their own small businesses. 

The unemployment rate is down to 4%, but we are only at 87% of pre-pandemic worker levels and are missing 2.9 million people.  The pool of available workers is at 12.217 million in January, which is 2 million higher than in early 2020.  Yet, mysteriously, we are still short workers. 

 

The Fed

We are entering another cycle of Fed tightening.  They will be raising the Fed Funds rate starting in March and are likely to raise it a total of four to five times (.25% each) by the end of 2022.  They met their objective of getting unemployment back to full employment, estimated at 3.5% to 4.3%, and now they must tighten against the highest inflation in 40 years of +7.5% and the tightest labor market in terms of wages increases in a decade, at +5.7% in January.

Market interest rates have risen in anticipation of Fed tightening.  In just six weeks, the 2 year Treasury is up .76%, the 5 year is up .40% and the 10 year is up .42%.  Both 15 and 30 year mortgage rates are up even more at +.80%.  The Fed is very happy to have the markets do some of their job for them.   Remember that Fed policy operates with a lag.  By the end of 2022, we should see the economy slowing and hopefully inflation receding.

Finally, all of you Phillips Curvers are rejoicing right now.  After 10 years of warning us that low unemployment leads to high inflation, you have finally gotten your moment of Schadenfreude!  Enjoy and thanks for reading!

DJ  02/19/22

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with Penn Community Bank and its predecessor since November, 2004. She is the author of Just Another Good Soldier, and Honoring Stephen Jaworski, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure of devotion.

She also was our guest on my firm's January 2022 podcast, This Month in Banking. To listen to that episode on interest rates and the economy, click here or go to wherever you get your podcasts.

Bank Customers Lose Real Money

You worked hard, saved money, and reduced or eliminated debt. You've been conservative, preferring the stability and security of bank deposits versus the gyrations of the market. Now, after forty years of toil and delayed gratification, you're ready for retirement.

If this were 2006, things would be good. The Fed Funds Rate stood at 5.25%, and inflation in check at 2.5%. This means you could get roughly 2.75% real interest from your bank savings account. Your money grew.

Then, boom, the 2008 financial crisis. The Fed immediately dropped Fed Funds to a range of 0% - 0.25%. And at that time, inflation was nearly zero (0.1%), so your real interest was still positive. And since it was a financial crisis, no worries. Things would recover. And thankfully since you were nearing retirement your home wasn't leveraged to the hilt and then some. Sure, your home value declined, but what does that mean to someone with little to no mortgage and isn't in the market to sell? 

Heck, maybe there'll be a reassessment and your real estate taxes will go down.

Taxes go down? See that. I made a funny.

Retiree: That's Not So Funny

To the retiree that prefers the safe haven of FDIC insured deposits held at the local bank that lends it out locally, this is a serious issue. If we use the Fed Funds rate as a proxy for what a saver earns at their bank, the chart below is alarming. 

Source: US Inflation Rate by Year: 1929 - 2023 (thebalance.com)

Things looked good as we entered the 21st century. Sure inflation was relatively high, at least above the Fed's target rate of 2%, at 3.4%. But the Fed Funds rate, as proxy for savings, was 6.5%, a full 3.1% real return. (Note: I checked a few of our strategic planning peer groups to see their cost of deposits at June 30, 2021. One peer average was 36 basis points and the other 37. Although this is higher than the current top guideline of Fed Funds rate of 25 basis points, I feel comfortable using it as a proxy for bank savings rates. Eleven basis points difference to the peer median... c'mon.)

If a saver put $1,000 in a bank savings account on January 1, 2009, less than one month after the Fed dropped the Fed Funds rate to 0%-0.25%, and kept it in that savings account, they would have $1,091 at the end of 2020. That same $1,000, invested in the S&P 500 Index for the same period, would be worth $4,318.

Worse, in 14 of the 21 years from 2000 through 2020, the inflation rate has been higher than the Fed Funds rate. Meaning keeping your money in cash, or at your bank, caused a decrease in your depositors' buying power. 

This caused savers to flee to higher earning assets, driving up the value of those assets. This phenomenon, combined with the Fed increasing its balance sheet from $1 trillion to near $9 trillion since the financial crisis, has kept bond yields low and their prices high. Forcing savers into equities, which has driven markets up. I can't imagine those that seek a safe haven will go into crypto currencies. But never say never.

This is a great environment for borrowers and spenders. Not so much for savers and those that avoid leverage. 

What Say You, Mr. Powell?

And I'm not so sure policy makers have the savers' best interests in mind. The current inflation rate at this writing was 5.3%, well above the Fed's 2% target. Yet they continue to signal that they will keep the Fed Funds rate where it is until 2023. The two Board Governor hawks that are calling to do it sooner are leaving. 

It benefits the federal government to keep rates artificially low because we have $28T of debt to service. That's with a "T". I'm hopeful the Fed makes decisions to promote maximum employment, stable prices, and moderate long-term interest rates. And ignores politician's calls to continue to print money to keep bond yields low so they can keep swiping the national credit card.

But I'm becoming increasingly skeptical that the Fed is remaining faithful to its mission. So as an industry, we might have to solve for the diminishing value of our customers' deposits. It could be part of our higher purpose (Increase economic well-being of savers).

If you have thoughts on solutions, I would love to hear them.

~ Jeff

Please consider reading my book: Squared Away-How Can Bankers Succeed as Economic First Responders. 

Ten percent of author royalties go to K9sForWarriors.org, who work to bring down the suicide rate among our veterans. 

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Guest Post: Managing to the Margin by Mike Higgins Jr.

It's that time of year when every CFO is trying to "predict" what is going to happen with rates as they construct their budgets for the new year. Rather than trying to predict rate changes in the budgeting process, consider a slightly different approach that manages to the margin.

In a nutshell, budget rates flat. Do allow assets and liabilities that are maturing to reprice at current offer rates, and budget growth at current offer rates too; just don't kick any rate hikes into the budget.

Here are the benefits of this approach:

1.  If budgeting rates flat, as described above, and margin is improving, then some of it could be due to repricing at current offer rates, but it also could be because of a strengthening product mix (i.e. higher mix of loans vs. investments and/or higher mix of low cost of funds vs. high cost of funds). Either way, it presents the truth about where you are at right now.

2.  If budgeting rates flat, and margin is declining, then it may signal a weakening in product mix, or simply a weak product mix to begin with, and that will lead to some very hard questions about the direction the bank is headed. It forces the bank to confront their financial reality and identify strategies and tactics to improve it. Banks that rely upon rate hikes to hit a number in their budget scare me. It's normally because they are covering up a weak or weakening product mix and that's akin to allowing a sickness to go on undetected.

3.  Lastly, budgeting rates flat makes things easier to explain to the board each month. If margin stays unchanged, then there is nothing to report. If margin changes, then you can simply explain why it happened, which is a lot easier than explaining why something did not happen. Remember, you report earnings to the board twelve times a year; you won't have to remind them in each meeting that your "prediction" about a rate hike was wrong.

On the flip-side, there is one benefit to including rate hikes in your budget; when they don't materialize as planned, and you miss your earnings target as a result, it gives you someone else to blame.

What are your thoughts on this topic?

Mike Higgins, Jr.

Mike Higgins, Jr. is managing partner in the firm of Mike Higgins & Associates (MHA). His consultants work with clients in the financial services industry. His primary areas of focus are performance management, performance-based compensation, board education and strategic financial planning. He can be reached at (913) 488-4506 or mhigginsjr@mhastakeholders.com

Guest Post: First Quarter Economic Review by Dorothy Jaworski

Spring-At Last

We are all thankful to leave the brutal winter of 2014 behind, especially the polar vortex! The constant barrage of snowstorms was mind numbing. The ice storm that hit our region (Philadelphia Region) with damage and over 700,0000 power outages was perhaps the worst storm. I missed being on the eastbound Pennsylvania Turnpike by 30 minutes on February 14th. For that, I am truly thankful. The lost productivity cost our local economy greatly. and the lasting legacy of potholes will keep drivers on their guard for months!

But it is pring and a new beginning. The equity markets are reaching new highs, expecting the economy to emerge from the deep freeze in the first quarter. GDP is expected to rebound from 1% to 1.5% in the first quarter to its "normal" mediocre growth rate of 2% to 2.5% in the second quarter.

Long term interest rates remain near their highs of last year, with the 10 year Treasury trading around 2.75%, as a result of the Federal Reserve tapering of their QE bond buying program. The bond markets unwound the benefits of QE during 2013, so it quickly became apparent to the Fed to reduce it. Rates would be much higher today if the economy was expected to grow more than the rates I indicated here. Markets are ignoring would events, such as Russia's annexation of Crimea, further unrest in Ukraine, earthquakes, and the missing Malaysian Airlines Flight 370.

We have a new beginning at the Federal Reserve, too.  Janet Yellen was sworn in as the first female Fed Chairwoman and she is expected to rule an empire in the same traditions as her two predecessors, the Maestro and Big Ben.  She worked for both men and is a fan of each.  She is a proponent of studying the data and is not fooled by numbers that do not provide the full picture of economic health, such as the unemployment rate.  She learned her first lesson at her first press conference.  When asked to define “considerable time,” she blurted out “six months or that type of thing” without thinking.  What?  “Considerable” is that short?  Bernanke always implied it was years!  Bond markets quickly adjusted to rate hikes sooner than expected.  I don’t think she meant that at all.  Nearly five years into our “recovery,” she knows that she must keep short term rates low to improve employment and prevent inflation from getting too low.  She knows if she tightens too soon, economic growth could stall.

Cautious Growth for 2014

We still expect that GDP growth for 2014 will be between 2% and 2.5% nationally.  Once the country recovers from the brutal winter in most parts of the US, growth will resume but uncertainty will remain, as businesses and consumers adjust to the new healthcare laws, regulatory burden, and general discomfort with the economic outlook.  Many of our bank customers remain reluctant to borrow and spend on large projects.

The Federal Reserve released their updated economic projections on March 19, 2014.  Generally, they lowered their GDP projections for this year and the next two slightly, kept their inflation forecasts about the same- still at 2% or below, and lowered their unemployment rate projections due to structural problems with the rate falling from persons exiting the labor force and lower paying jobs being added.  They slightly raised their Fed Funds projections, including an earlier increase of the Fed Funds rate from the prior December projections.  The market interpreted this as tightening sooner than had been built into the term structure.  Janet Yellen, when asked directly about this change in the scatterplot, stated that we should “ignore” it and pay attention to Fed statements released after their meetings.  Here we are- back to the good old days when everything the Fed says is vague!

Fed QE Programs

I am of the opinion that the QE bond buying programs served to reduce long term rates and were initially successful.  During 2012 and 2013, long term interest rates, including mortgage rates, fell and contributed to an improvement in the housing markets, allowing home price increases to gain some momentum and prompt the new construction markets to improve.  Then, the Fed mishandled their message on QE early in 2013 and the markets abruptly removed its favorable impact, sending long term rates soaring over 100 basis points.  This type of increase is very rare in a declining inflationary environment, but we live with it.  With the markets having removed the benefits of QE, the Fed began “tapering” the program, which started at $85 billion per month last year and is now at $55 billion per month.  Markets expect the Fed to continue reducing purchases by $10 billion per month until it is down to zero- in October or November, 2014.  So our question to Janet is:  What will you do if the economy stalls and you need to ease?  Her answer:  More QE!

By the way, Europe is about the start up a QE bond buying program for the first time- to the tune of $1 trillion Euro to help the struggling economies, where growth turned positive, but only by about +.5%.  Mario Draghi, the head of the European Central Bank, is revealing his plans to the International Monetary Fund for buying sovereign debt, or maybe even private debt!  Later, he will make a public announcement.  The European markets are abuzz with speculation, but it will not be the first time Draghi has proposed something big and not followed through on it.  Yeah, like negative interest rates, Mario!  Stay tuned!

Discovery of the Waves

Albert Einstein predicted in 1915, in the general theory of relativity, that the universe contained gravitational waves, left over from the Big Bang billions of years ago.  A second theory developed in the 1980s predicted these waves as part of a process known as cosmic inflation.  An instant after the Big Bang occurred 13.8 billion years ago, the universe expanded exponentially, inflating in size trillions and trillions of times.

An announcement by the Harvard-Smithsonian Center for Astrophysics in Massachusetts on March 18, 2014 stated that researchers have discovered the gravitational waves, confirming both theories, by looking through telescopes on the South Pole.  This is another monumental breakthrough in understanding the universe, after the discovery of the “God particle” by the Large Hadron Collider team in Switzerland last year.  Yeah, now we know!  Now, if we could only predict interest rates!

Thanks for reading and Happy Spring!  DJ 04/07/14

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.