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Fed’s Long Pause Credit Neutral for U.S. Banks, Fitch Reports

March 22, 2019, 08:11 AM
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The Federal Reserve's dovish stance on keeping the Fed Funds rate at its current level for the remainder of 2019 will pressure U.S. banks' revenue. However, the rate pause may also prolong the benign credit quality environment, according to Fitch Ratings. While a prolonged pause in rate hikes could provide relief to the banks' increasing funding costs, we ultimately believe that net revenue could be pressured as yields on loans and securities are likely to remain flat for the remainder of the year and into 2020.

On March 20, the Federal Open Market Committee (FOMC) announced that it would be holding the Federal Funds rate at its current level of 2.25%-2.50%. At the same time, the committee indicated that it would pause on further rate hikes for the remainder of the year, a material change from its December 2018 meeting when it had pointed to two rate hikes for 2019. As shown below, the median projected year-end 2019 policy rate has now dropped to 2.375% at the March 2019 meeting from 3.125% at the September 2018 meeting.

A more dovish Fed is credit neutral for U.S. banks. The FOMC's rationale for a rate pause has primarily been driven by a downgraded view of global economic growth trends, which have slowed from their solid rate in 4Q18, according to the Fed's projections. Still, the committee also acknowledged that the U.S. labor market remains strong and that inflation remains below a targeted 2% level.

Compared to other tightening periods, banks across various asset sizes and business models have taken advantage of rising rates since 2015 due to a relatively higher starting level noninterest-bearing funding as well as lower funding leverage (i.e. lower loan-to-deposit ratios).

A long pause in rate hikes will likely hamper margin expansion for most of the banking industry, a credit negative, as variable-rate loans halt repricing upward and re-investment rates within bond portfolios flatten out. Moreover, with net interest income growth most likely to come from loan volume growth, loan spreads could come in as banks continue to compete for profitable business at a relationship level, further pressuring net interest margins.

However, the long pause in rate hikes could provide some incremental margin expansion for banks that have been most aggressive in raising deposit rates during the current tightening period. These primarily online or mobile banks are likely to continue to see deposit inflows at status quo rates while the rate differential between those banks that have passed along a lower level of rate hikes to depositors (and thus have lower deposit betas) gradually catch up.

The projected long pause could extend the period of benign credit quality across asset classes within the U.S. as borrowers get incremental relief from growing debt service costs, which is viewed positively. As noted above, borrowers with variable-rate loan pricing will likely get respite from increasing benchmark rates such as Prime Rate and LIBOR. However, a global slowdown in economic growth could also bring lower revenues and margins for U.S. corporates, lower levels of free cash flow to service debt.

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