Investment Observations and Ideas for the Fourth Quarter

Intro: Helping community bankers grow themselves, their team, and their profits, this is The Community Bank Podcast.

Caleb Stevens: Hey everybody, and welcome to Episode 60 of The Community Bank Podcast. I’m Caleb Stevens, and I’m joined by Tom Fitzgerald. Tom, how are you doing today on our 60th episode?

Tom Fitzgerald: Well, Caleb, the time has just flown by. I’m doing great and I hope you are as well. But 60 episodes? Wow. I think when we did the first one, we would just hope to get through a half a dozen, and maybe we wouldn’t be fired by then.

Caleb Stevens: Yeah, we were thinking maybe once a month, maybe every two weeks. And we’ve tried to stay dedicated and consistent with the once-a-week cadence here. And so we appreciate you guys, this really is your show. Without you, we wouldn’t be doing this. So thank you for your support. Thank you for listening. We get a lot of feedback from you guys each week. And so appreciate you guys tuning in. And Tom, you really haven’t been on the show in a while and so it’s good to see you back on the show. For folks that don’t know this, we really don’t release every episode in the order that we record them, we try to get a feel for what needs to come next. And we don’t like to have too many shows of the same topic, you know, lined up back to back to back so we often don’t release them in the same order. And so Tom, you really haven’t been on a show that we’ve recorded here in a while. So it’s good to see you back. And it’s good to have Chad McKeithen back as well to talk about the economy. So I thought that was a good conversation.

Tom Fitzgerald: Yeah, obviously, you know, the economy is sort of things are really breaking as we move into the fourth quarter with the government is kind of struggling with how to get the continuing resolution passed to fund the government into the fourth quarter. The debt ceiling limitation is staring us right in the face. So a lot of that’s going on. The Fed just had a meeting, which was very, very important, very consequential. So a lot of stuff swirling right now. So we thought this would just be a very timely episode, as we move into the fourth quarter.

Caleb Stevens: And just for context, this is dropping, I believe on Monday, October 4th, and we’re recording this on Wednesday, September 30th. So just FYI, if something happens crazy between now and next Monday, we apologize because we were not there.

Tom Fitzgerald: Yeah, that’s right. Like you said, this could be a very consequential weekend. So we’ll just kind of just throw out that caveat that we’re kind of in this before it all happens.

Caleb Stevens: Well, let’s go to that conversation with Chad and Tom right now.

Tom Fitzgerald: Chad McKeithen, it is great to have you back on our show again. How are you doing?

Chad McKeithen: Good, thank you.

Tom Fitzgerald: You know, these investment shows are some of our most listened to, and certainly as we head into the fourth quarter, and with everything that’s kind of transpired up to this point, I’m sure this one will be also one of our most listened to shows. And I think our listeners are really keen on kind of what you have to say, and what we both have to say as to what we think we’re going to see, not only for the fourth quarter but obviously moving into 2022. You know, I guess we have to say, as we record this, we had an FOMC meeting last week, the September meeting, probably one of the more consequential meetings of the year. Every time you get a quarter-end meeting, Chad, you know that, you get the updated forecasts, you know, both the rates and the economic forecast, and this was no different. You know, the tone, I think, coming into it, the tone was a little more hawkish than what we expected to hear. They kind of moved forward at a hike into ’22, you could call it. They were kind of half, half of them were in for that hike, half of them weren’t. But anyway, you look at pushing a hike into ’22, that was not in the June forecast. They’ve still got two hikes and ’23. So there was a little bit more hawkishness, I think, and also kind of what surprised me and I’d like to get your take on this too, Chad is that the press conference, Powell was pretty clear as to the fact that we’re probably going to see a tapering announcement in November. And that when the tapering begins, which is probably going to be December or January, that it’s going to run through the end of or the middle of next year. And I think that was a little more clarity than the market was expecting. Was that your take too, Chad?

Chad McKeithen: Yeah, you know, and you got to commend the Fed, I mean, and whether it’s Powell or the collective group, because if you go back to some of the same periods of time back in, say, 2012 through 2015, when that discussion of when it’s time to pull back some of the accommodation, you know, it was a lot more volatile during that period. One of the things that we always struggled with here, and it’s the same thing that a bank is going to struggle with is, you know, when do I buy a bond? What’s the risk in that holding of positions? It’s the same thing from our standpoint. “When do we structure bonds? When do traders hold inventory?”, etc. One of the tough things back in ’13 to, say, ’15 was that the market, the futures market was well off of where the Feds say dot plots were forecast. And today, they’re almost exactly lined up. You look at the dot plots ’22, ’23, you look at a Fed Funds futures where the market is trading the expectation for rates, they’re on top of each other. The end of ’23, they both show about a 1% Fed Funds. Fed Funds futures show the same thing as the dot plot. So you kind of got to applaud them a little bit. They’re giving a much clearer picture, a direction.

You know, the last time we even heard the word taper in 2013, the markets gyrated for about six straight months confused on what the Feds, you know, what their plan of action was.

Tom Fitzgerald: They freaked out basically for a while.

Chad McKeithen: Yeah, yeah, freaked out and look, the Fed Funds futures market back then was almost 200 basis points lower than where the dot plot forecast was back in, say, 2012, 2013, where the dot plot was forecasting a much faster rate hike. The futures market ended up being correct. That rate hike did not happen over the next two or three years. But you don’t really want that. You want the market to not be caught off guard or be taking excessive risk, you know, with inventory or with anything that they’re doing. So got to applaud them firsthand. And we knew going into that meeting that there was probably going to be a slight hawkish tone. It maybe came out a little bit more hawkish than what was expected going in, but the market didn’t fall apart. You know, we saw a little pickup in yields, but nothing compared to past times when we’ve been in quantitative easing periods.

Tom Fitzgerald: Right. And like you said, you have to kind of tip your hat to Powell that, you know, he’s kind of been very transparent leading up to this, and kind of setting a pretty long runway that you know, “We’re going to taper but it’s going to be a process that you’re all going to know about.” And I think he’s kind of set it up pretty well as we move into, like I said, the end of the year. There’s a November meeting, there’s a December meeting, so the thought is that they announce it in November, they probably start rolling it out in December. And like he said, he kind of admitted that we’ll be done by the middle of ’22. And then that sort of sets you up to say, “Okay, now the clock starts ticking for potential rate hikes,” which like we mentioned, half the committee was saying, “We’re going to go in ’22,” half said, “No, we’re still going to wait for ’23.” But, like you said, the market is already anticipating, kind of penciling in that probably late ’22 is when we see the first rate hike. And the markets kind of absorbed that news, I think pretty well. And again, that’s a testament to the transparency and I think the communication that Powell has given the markets.

The other thing that I think was interesting too, was when you look at kind of their, like we talked about, they do the rate forecast, and they update their economic forecasts like you said, they downgraded that 7% GDP number that they had in June, given the sort of the slowing that we’ve got because of the Delta variant cases rising and so forth. And so they kind of tapered that off in the GDP estimate. But then they kind of upgraded a little bit to ’22, you know, from 3.3 to 3.8. But, you know, what struck me when you kind of look at the out years, ’22, ’23, ’24, they see that GDP trend moving pretty quickly back to the pre-pandemic levels that we were used to, two, two and a half percent. And also, the inflation numbers kind of drifting back down to that 2% level. I think they had them like 2.2, 2.1% as we move to the out years. But, you know, they seem to think that we are going to get back to those pre-pandemic levels over the next couple years, kind of the numbers that we were used to seeing, right, prior to COVID.

Chad McKeithen: Yeah, I agree. And it’s one of the things that you know, we sit on some different alcoves and it’s one of the things that we’ve kind of discussed is everybody is– You know, you get in these periods where rates are very low like this and you kind of get one of these eye-popping kind of GDP forecasts. And again, I think you kind of got to do the same thing with some of the GDP forecasts right now that you’re doing with some of the inflation. You got to discount it a little bit because we’re looking at typically year over year numbers, so you know, is a 5.9% GDP for the year, is it that strong, or is it just the baseline of last year what we’re coming off of was so low? And it’s some kind of mix, but a lot of our clients, a lot of our bank clients are really kind of taking some of that and then of course taking, “Okay, well now we’re hearing this word taper,” and they’re starting to gear their balance sheets and their portfolios up for a rising rate environment. And that’s fine to do that. There’s nothing wrong with adding in some protection against that type of environment.

The thing that has changed due to so much of the tapering and Fed stimulus, I mean a fiscal stimulus as well too, is on top of monetary stimulus, you know, is the savings and the liability side of the balance sheet has changed so much over the last decade from what the Fed has done. And so we definitely are trying to stay somewhat liquid, keep cash flow strong. We don’t know when loan growth comes back, we don’t ultimately know when rates do go up. But at the same time, you just mentioned it, you know, after you get through this year and a little bit into next year, those GDP numbers start to come back and there’s still a lot of stuff going on in the economy that could be disruptive. So while we have a lot of clients focused on the short end, and maybe rates start to go up in late ’22, or ’23, you know, it’s really that balanced approach, I think, for managing the balance sheet and the bond portfolio. Some call it protection, but also some short cash flow in preparing for maybe some type of loan growth or rate increase in the next one to two years.

So that’s kind of how we look at the GDP. Some of the numbers they’ve come out with are still pretty robust this year, starts to slow down again a little bit next year. And like you said, you get out there in about two years, and you start to see some numbers that they’re okay growth expectations, but I would say on, you know, the historical basis, they’re getting back to the lower side of growth.

Tom Fitzgerald: I think you’re right. And I think that’s one reason why, you know, we haven’t seen– Now, again, as we record this, we went through the Fed meeting, and then we had four straight days of yields backing up from, let’s say, 130 on the 10-year to over 150. But again, I think the market, obviously, they look forward, they look at those out years and say, “Well, the expectation probably is that, like you said, we’re going to see growth kind of trending back to the mean, we’re going to see inflation trending back to the main,” and so that means we’re sort of in that lower for longer rate environment, probably for a period of time. Even though we might get these little spikes in rate, you know, backing up for us, that catalyst to see rates moving over 2%, let’s say on the 10-year, and then above that, it’s just it’s hard to kind of envision that, hard to see that catalyst that’s there right now, given the forecast that we’re looking at, both for the growth, both for the inflation.

And again, part of what we saw with this backup, and I wrote about it in the last couple days, was that the inflation’s probably going to be a little bit stickier than we thought, you know, the Feds kind of admitted that. The growth prospects probably in the fourth quarter are going to be better than they were the third. I think the Atlanta Fed’s GDPNow is about a 3.2% number, which is, you know, compare that to the second quarter when we did 6.6. But then the fourth quarter you’re looking at it bouncing back over to 5%. So I think the markets are kind of digesting that. We’re probably going to see a little bit better growth in the fourth quarter. We’re going to see a little stickier inflation and so that warrants a little bit of a backup in yields. And I think that’s kind of what we’re seeing in the last few days, but I think longer term, they look at those long-range projections and they say, “We’re really not in an environment where we’re going to see materially higher rates,” and I think these little backups probably are more of a buying opportunity than anything else.

Chad McKeithen: No doubt. Yeah, I mean, this is a gift. Again, you know, you look at longer-term, I mean, this morning just we were doing some rate prognostication, we were looking at futures. I mean the 10-year Treasury doesn’t show it hitting 2% in the next three years. So you know, we get these little bumps and sometimes you get a knee jerk reaction from clients of concern, rates are going up but the market still, long-term is it’s pricing this– You know, you’ve got now, I looked the other day, I mean, between Fed stimulus and monetary stimulus, so in effect, the balance sheets of those two, you know, the debt on the fiscal side and the direct easing on the monetary side, you’re talking about $36 trillion. And you go back a little over a decade and I think it was around 14 or $15 trillion. You’ve injected that amount of money into the system to some degree or another, whether it’s buying mortgages or it’s subsidies, whatever it may be. That’s a lot of liquidity for the market to absorb.

And you know, as far as long-term rates rising, you’ve got to factor that in that it’s going to– Whenever you put a lot of money into something, it lowers the sensitivity of that. And you know, it’s like anything else, you give more and more supply to something, and you lower the risk to that or the sensitivity to that. So I think you know, without trying to hit the number exactly, what’s going to happen to Fed Funds futures or the 2-year Treasury or the 10-year Treasury, we’ve got to factor through over the next 5, 10 years, a lot of liquidity. And the market is pricing that in right now that that should keep rates relatively low. We might get little pops, you know, five years up, almost 20 basis points in the last two to three weeks. To me, that’s a buying opportunity. You know, it’s an opportunity for especially the folks on this podcast – banks – that are dealing with a lot of liquidity to take some of that and put it into any intermediate part of the curve. And so I agree, I think it does serve as a little buying opportunity.

Tom Fitzgerald: Well, let me ask you too on that. You talk to clients every day, what strategies are you working with, with these clients on kind of a– You know, what is working? What do you see working as we move into the fourth quarter, given what we’ve just sort of laid out in the economic and rate environment?

Chad McKeithen: Yeah, well, I’m going to tell you, man, we’ve done two speeches in the last two weeks to different state bank associations, and both topics have kind of been centered around managing liquidity. And so when we’re talking about strategies, I mean, typically, my 25 years in this business, you’re talking about, “Well, I like value in this bond sector, or I like this part of the curve.” But really, the biggest, I guess, risk to me is the lack of use of cash. And this has been sort of hidden this year. Banks have had heavy revenue, non-interest income, fee income growth from the PPP program, and then just heavy loan refi. And then some banks just, you know, reversing the reserve requirement that they have. But those three sources of income are not long-term income sources, and they’ll go away, and they already are starting to go away. I think the third quarter will still be a strong quarter for most banks, as they continue to realize some of those, but I think the fourth quarter is going to be difficult.

We sat last week on an ALCO, and one of the board members said, “Turning to 2022 on revenue is difficult. Net interest margin, what we were talking about 18 months ago, net interest margin is going to tighten, we’re going to be in trouble.” That got hidden a little bit with that fee income production. So now we’re getting kind of back to the reality of really fundamental banking. The one thing we know is most banks have a ton of cash.

We did a little cost of cash calculator in one of those state associations last week, and one of the interesting things I was just looking at a three year CMO, you know, about a 120, three-year duration CMO, about a 120, 125 yield on a structure like that, versus sitting in cash for one year. And you needed rates, you needed the rate to go from 0.08%, which is about the Fed Funds rate right now. In one year, if you sat in that cash position, you needed those rates to go from 0.08, up to 1.67%. So in essence, 160 basis points. Well, nobody, the market is not forecasting that in one year, that’s not even close to forecast. The cost of cash, to me, is about as high as I’ve ever seen it. And the thing that we try to kind of portray in ALCOs is that you have a lot of it. And it does seem like the deposits are remaining sticky. Most banks are now forecasting that savings are going to remain high. And since ’08, since the last recession, we have seen personal savings rates almost stay double what they were prior to the ’08 recession. So depositors are fine keeping their money in banks earning nothing. And so my first strategy is understand that cost of cash and are you as liability sensitive? Or do you need that much asset sensitivity that you’re holding down in cash? I think that’s the first strategy is figuring out what’s that excess cash, what you don’t think is going to be a bleed from deposits leaving the bank or that you’re going to have at loan growth, and start to put that to work. And again, with this pop in yields in the intermediate part of the curve, three to five years, you’ve got kind of an opportunity now to take advantage a little bit more of that kind of short duration type of investment.

You know, the other thing, one of the biggest things that we’ve had the luxury of over the last 18 months, Tom, is the taper. I mean, I’m sorry, the mortgage buying program. The Fed has been buying $40 trillion every single month, of mortgages. Well, we have had bids on mortgages that we’ve owned, so clients have owned these mortgage back securities or CMOs, and there’s been strong bids on those. So a lot of the fast paying mortgage backs that were produced back in ’18, ’19 that had been targets of the servicers, these refi servicers to extend and refi, that’s going to go away with the taper ending. So one of the things that we really kind of honed in on here over the last month or two is if that does start to peel back a little bit, say in November, December and through the middle of next year, you’re going to lose some of those bids on those bonds that maybe still have premiums, maybe still have higher coupons, they have low historic yields, you know, something under 50, 60 basis point yield range. Why am I going to hold something like that if I can get a good bit on it? If that bid goes away, they stop the buying, then that bid goes maybe back to losses. And so some of those cleanups and that I think is a great strategy. And then just the curve statements along the front, the first one to five years.

Again, I saw something yesterday, it said that the 5-year Treasury moved up in the last few weeks more than three standard deviations away from its average. It’s only the fourth time it’s done that in the last five years that there’s been that big of a movement. You got a lot of curve steepness on that front end of the curve. A year ago, we were talking about, “Hey you need to get up to the 10-year part of the curve to get some of that curve steepness and that potential roll down that you get from call protection or a bullet-style maturity.” Now you can get that roll down from the five-year segment of the curve, so it’s making it a little bit less interest rate risk-sensitive to get some attractive part of the curve. And then another thing, we like tax-free munis again. I mean, whenever we look at munis, you always look at spreads or the muni-to-Treasury ratio. You know, that muni-to-Treasury ratio last quarter was in the 50% range, that’s the 10-year muni yield divided by the 10-year Treasury yield. It was in the 50% range and that was historically low, but it’s slowly come back up into that 70% range. And we’ve seen a lot of clients layering in some call protection and getting back out there into the tax-free market on top of the taxable beauty market which has been hot for, you know, spreads, yields, etc. have been attractive there for the better part of a yield. But that tax-free market is starting to come back and I think that’s in a good spot where we might be getting some tax changes soon to layer in some of that value.

So I hope I didn’t leave anything out but that’s kind of it, you take advantage of this buying from the Fed, curves gotten really steep in this intermediate part of the curve and I think it’s a great segue off some of that opportunity cost of cash. Now you don’t have to get up to the 10-year part of the curve, you can take some of that liquidity, put it out in the three-year part of the curve, five-year part of the curve and not layer on a lot of interest rate risk but get that money to work because there’s no rate projection that says liquidity is going to be your best revenue generator over the next one to two years.

Tom Fitzgerald: Right.

Chad McKeithen: And so I know that’s broad but that’s kind of the strategies we’re kind of gearing in on, I’d say, going into this fourth quarter and trying to prep a little bit for 2022.

Tom Fitzgerald: And I think if I hear you correctly, I think some of the bankers this year have been able to sort of kind of ride that non-revenue income stream from the PPP loans and some of the other sources that you talked about, the reserve kind of release back into income. Like you said, that’s going to go away so that kind of crutch that they’ve been kind of riding on is probably not going to be there in ’22, so it becomes a matter of, “Where do I find that revenue that I’m not going to get from those sources?” And you look at the loan demand which has been kind of soft through this, which was a little bit surprising, I think, that the consumer hasn’t come back in the lending market but like you talked about, they’re flush with liquidity. They don’t need as many car loans or home equity loans that they probably needed in the last cycle. And if that persists into ’22, then like you said, you’re going to really have to kind of really sharpen that pencil to say, “Where am I going to get that revenue if I’m not going to get it from loan demand and I’m losing some of these non-revenue sources in ’22?” So I think those are good points that, you know, you don’t want to just sit there and all of a sudden go, “Wait a minute, what happened to my income because it’s not where I thought it would be?”

Chad McKeithen: Well, and I think this is a good time as anybody. I mean, I think bankers have to get their mindset right a little bit. There’s a paradox to higher savings and you kind of touched on it a second ago. I mean, you increase savings and the depositors in the banks typically need less leverage, they don’t need as much, they don’t need to borrow as much. I mean, again, liquidity is high. Depositors from the commercial side to the consumer side, they have a lot more money right now, and is there something that’s going to draw that savings down? My point is what the Fed has done since they started quantitative easing is they have upped the level of savings and depositors have shown since that ’08 recession that they’re more comfortable holding savings high and that typically– It’s kind of like you know, there was an article that came out last week that highlighted that there was confusion from bankers that home equity loans were remaining so low when the value of homes was so high. But you know, I’m reading it and thinking, “Well, it’s perfect. I mean, it’s it makes complete sense because they have a lot more cash.

Tom Fitzgerald: Right.

Chad McKeithen: And what’s the purpose of needing the loan if you don’t need that cash? Now, will it come back? Certainly. There will be some loan growth at some point that will come back. But my main point about the deposits is I do think banks need to kind of look at their deposit side of the balance sheet and look at it as a low-cost product. I think one thing that the TD Ameritrades, the Robin Hoods with this float that they do where they don’t pay fees whatsoever, but they give you benefits, either free transactions, I think that needs to be somewhat this layering into the banking system for future revenue is that, “We’re not going to compete for deposits anymore, but what’s our way of generating some value to you in other formats? I’m going to generate my revenue based on low cost of funds because my yield earning assets is probably going to be tight for the next five to 10 years, spreads are probably going to remain tight. So how am I going to generate that other source of fee income and not compete on the deposit side?”

And I think it’s kind of like that first airline that started charging for baggage, everybody said, “Oh, it’s going to hurt that airline.” But then, as they started to do it, everybody else started to do it. It’s kind of like these other groups have started to pay nothing for your funds, but they’re generating other sources of value for you. And I think that’s the way banks got to kind of shape their mindset. You’re not going to be liability sensitive any longer, you’re going to have to do some different things on the asset side of the balance sheet to generate some revenue, and then generate some other things internally that are going to incorporate more fee income. But anyway, that’s a little off that topic, but I do think that’s some things that we’re typically talking to some of our clients about a little bit.

Tom Fitzgerald: Yeah, and that’s a good point. And also too, kind of going back to the consumer, you know, when you look back at August, the University of Michigan, that sentiment number just dropped out of bed, basically. It was the lowest number, what, in a decade, I think, as far as the sentiment.

Chad McKeithen: Yep.

Tom Fitzgerald: And then The Conference Board number came out today for September and that number tends to be a little bit less jumpy or volatile than the Michigan number, but it dropped as well. And it dropped and August and they thought it was going to balance in September. It didn’t balance in September, it dropped further. So, to me, that implies that the consumer is still hesitant about trying, you know, to getting out there. And if you’ve got confidence that’s sort of ebbing, or at least not accelerating, then that means to me that I don’t expect that we’ll see expanding loan growth anytime in the near future.

Chad McKeithen: No.

Tom Fitzgerald: So I think what you’re saying is that don’t expect just because the calendar turns to ’22 that all of a sudden the consumer is going to show up and say, “I need the car loan. I needed a home equity loan.” That may be a little bit longer coming than we might think as we sit here today.

Chad McKeithen: I think one point to this, and I was at a Kentucky Bankers Annual Conference last week, and I’m going to tell you, the majority of the presenters up there were M&A presenters, mergers and acquisition presenters. And the common message we continued to hear was loan growth is going to be low and therefore, institutions are going to be very interested in purchasing loan growth by acquiring other institutions. And so that typical organic loan growth that we always just expect to come back after we’ve gone through a low period, it’s probably going to be less than what we’re historically used to. And so you got to get in ALCOs and with boards, etc, and kind of, you know, like I said, get your mind right a little bit and start to realize that the liabilities side of the balance sheet has been turned 180 in the last 10 years. It’s not this, you know, “we’re chasing deposits,” there’s no more deposit chasing. And the whole market is getting that way by not paying things for, not just the banking side but anybody that holds funds is getting away from that kind of sensitivity of funding. So what are we going to do on the other side of the balance sheet?

Net interest margin, to me, is probably a dying breed of revenue. It doesn’t mean volume net interest margin is not important but the widespread, “I’m going to hit a home run with a four and a half percent net interest margin,” that’s been declining since the early 2000s. And so it is going to take more of that mentality of where do I buy? Where the curve is steep. Where do I buy bonds that maybe I do hope that they generate gains as they season and roll down the curve? And it’s going to take a little bit more of that mentality, and I think at least for the next five years or so. So I agree, I don’t think we’re going to roll the calendar year ’22 and Fed’s going to start tapering and all of a sudden loan growth is going to come back. I think it’ll be low through next year and we’ll see about into ’23.

Tom Fitzgerald: Yeah, I think it’s like you said. I think it’s going to be singles and doubles and not triples and home runs, that you’re going to have to kind of accept and try to find them where you can and take it and just be happy with that.

Chad McKeithen: Yeah.

Tom Fitzgerald: Chad, I just want to thank you so much for your time and your insight today. I know you spend a lot of time with clients and you kind of get that feedback going out and coming back in. So that’s very valuable, I think, to our listeners to be able to tap into that. So I just want, again, I want to thank you so much for sharing some of your insights today. And hopefully, we’ll come back in a few months and kind of see where we are maybe towards the end of the year, and kind of revisit and kind of start squaring things up and looking forward for ’22.

Chad McKeithen: You bet. Man, I love doing it.

Tom Fitzgerald: All right. Well, thank you, Chad. Take care, man.