What The Fed Pause Means For Commercial Loan Production

Commercial Lending Strategies

On October 30, 2019, the FOMC decided to lower the target range for the Fed Funds rate to 1.5% to 1.75%.  The decision was not unanimous, and two members voted not to lower the target range.   In the FOMC statement and at the post-meeting news conference, the committee’s communication was clear in that the future path of Fed Fund rate will be data-dependent, and the indication is that the “mid-cycle adjustment” is done.  The key takeaway is that rates may move up or rates may move down in the future depending on economic developments.  The question for many bankers and borrowers is how to view the banking business model in this environment.  What loans should bankers favor, and how should banks price commercial risk?


Historical View

The FOMC has moved from continued gradual increases in the policy rates from December 2018 to holding rates constant from January through June of 2019 to 75bps in cuts (July, September, and October).  These three cuts are deemed by some as “mid-cycle adjustment” and mirror the adjustments made in 1995 and 1998.  There are three reasons given for this mid-cycle adjustment: first, to mitigate negative international developments on US growth (e.g., trade wars), second, manage downside risks to the economy, and, third, to support the return of inflation to 2% symmetric target. 

In the 1995 mid-cycle adjustment, after three rate cuts, the FOMC kept rates unchanged for 13 months before raising them.  However, the 1995 Fed Funds rate was 6.00%.  In the 1998 mid-cycle adjustment, after three rate cuts, the FOMC kept rates unchanged for seven months before raising them 1.75% over the course of 12 months.  However, the 1998 Fed Funds rate stood at 4.75%.

It is difficult to conclude this mid-cycle adjustment from the two previous similar points in history, and while the FOMC is data-dependent and is policy-driven with the aim of continuing the current economic expansion, current FOMC members have clearly stated their dislike for zero or sub-zero interest rates.  The current Fed Funds rate is only six cuts away from zero, and the economy is now in its 126th month of expansion – the longest in US history.  The probability of preemptive rate cuts seems to be quite low – despite the taunting tweets.

Future View

While economic forecasters are notoriously poor predictors of the future, the graph below shows a composite forecasting view of Fed Funds Rate and the 10-year treasury rate out to Q1’21.  The forecast shows only one additional Fed Funds cut through the forecast period and the 10-year rate drifting just 25bps higher.

Fed funds rate history 


The forward market expects 10yr Treasury rates to drift higher for the next few years, as shown below.  The 10yr Treasury rate is expected to return to its average over the last ten years of approximately 2.50% (the market is not pricing a difference in the 10yr Treasury rate between 10 and 30 years from today).

The current forward curve 


The Fed Funds forward market only prices out to one year, and the expected future outcome of that market is one more rate cut.  However, the 1-month LIBOR forward curve trades out to 30 years, and the ten-year forward curve for that index is shown below.  Again, the market expects between one and two cuts from the FOMC and then slowly increasing interest rates.

1 month libor

Action Items For Community Bankers


Bankers should not be in the business of trying to structure loan products based on their prediction of interest rates.  However, having a long-term view of the interest rate market does gravitate strategy, positioning, and decision making for community bank managers.  Generally, there are three common views on the future path of interest rates and those views are summarized below.


Banker lending options given the current rate environment


Bankers who believe in a Japanification outcome or are planning for the possibility of such an outcome are well served to avoid allocating more capital to the business of banking.  A zero or negative yield curve is very disruptive and negative to the banking industry.  Japanification is also a reflection of fundamental social and fiscal problems in an economy that monetary policy is not well equipped to handle.  The Japanification scenario is a surrender of the economic principles of this country. 

The low forever scenario is also a low probability outcome.  However, under this scenario, the yield curve is low and flat.  Banks will be stressed to generate an acceptable return on capital as carry trade disappears, which historically has accounted for 1.50% to 1.75% of the average community bank’s NIM.  Efficiency will be key, and banks that gravitate to niche markets, larger loans, and better credit quality will outperform the market.  Borrowers will be motivated to lock in rates for longer, and banks that do not incorporate prepayment provisions will be losing customers to competition (a continued race to the bottom for credit structure and margin).  Community banking will survive, but many banks will not. 

The mid-cycle adjustment is the odds on favorite outcome in our opinion.  Interest rates tend to change course only infrequently.  In 1980 investors were looking back on 35 years of generally rising rates (an experience lost to most current working bankers).  In 2019, a different generation of bankers is looking back at almost 40 years of generally falling rates.  In banking, you can profitably spend a whole career not changing your mind.  However much we try to forecast and extrapolate, we tend to foresee nothing more than what we have recently seen.  

Taking a longer-term view may do bankers well at this time.  Paul Schmelzing, a Harvard University economic historian, looked at interest rates since 1311.  He explains that the world is currently in its ninth real rate depression.  Schmelzing explains that interest rate cycles are disrupted by demographic and geopolitical events (such as Black Death or world wars).  The graph below illustrates his view.

Risk Free Rate History

Community bankers should be primarily focused on the more likely outcome – that a current mid-cycle adjustment is a typical event in monetary policy and that barring a catastrophic recession or geopolitical tension, we should not expect anything as dramatic as Japanification in the US.  Interest rates will follow their rapid and nonlinear movements.  Bankers should be prepared for slightly lower interest rates and also substantially higher rates at the same time.  Taking interest rate or credit exposure without compensation has not done well for bankers historically and will not work in the case of this mid-cycle adjustment.  Good underwriting standards, managing relationships, avoiding unpaid risks will work better in the long run.