July 5, 2022
By Jim Dobbs
Community banks’ second-quarter results are expected to show increased interest income and profits as the impact of aggressive Federal Reserve rate hikes becomes evident. But it's not all good news — as rates climb further, depositors will begin to demand higher interest payments as well, eventually driving up banks’ costs.
This would come on top of already rising operational and staffing expenses amid a surge in inflation this year. Federal data shows inflation hit a 40-year high in May.
Analysts broadly anticipate rising interest rates to bolster banks’ bottom lines through 2022, but they will be focused on the expected spread between deposit costs and loan yields when banks report second-quarter earnings. Banks will also be expected to offer their outlook on the overall economy — whether it can hold up amid the surging interest rates or teeter into recession.
And a recession could easily curb loan demand and drive up credit losses.
“All eyes” are on the impacts of inflation and rising rates, said Piper Sandler analyst Frank Schiraldi.
Piper Sandler expects second-quarter earnings per share across the firm’s coverage to increase 1.5% from the prior quarter, Schiraldi said. Yet, “we expect this earnings season will be dominated by management commentary on the macro environment,” he said.
Up, up and away
To tame inflation, Fed policymakers in the spring raised interest rates by 75 basis points — from near zero — over the course of two hikes. They then thrust rates up another 75 basis points in June, the largest one-time increase since 1994. Policymakers have since signaled another rate increase is likely when the Fed meets later this month, and even more increases could follow.
With already high inflation unexpectedly exacerbated during the spring months by Russia’s war in Ukraine, bankers say the Fed determined it had to get increasingly assertive. Banks benefit when rates rise because their adjustable-rate loans reset higher, fueling increases in interest income. But most lenders prefer gradual rate increases because, historically, rapid rate hikes made borrowing too expensive. Business investment and consumer spending dropped, by extension, and the economy tilted into recession in past periods of aggressive rate hikes.
“The pace of rate increases now certainly looks faster than anyone had anticipated” earlier in the year, OceanFirst Financial Chairman and CEO Christopher Maher said in an interview. “I think it’s going to be a sharp cycle.”
He anticipates at least a mild recession in coming quarters. “You have to be aware of potential stress,” Maher said.
The $12.2 billion-asset OceanFirst Financial, which is based in Red Bank, New Jersey, benefited from strong loan demand and growth in the first half of the year, and momentum continued into July, Maher said. But the outlook grew much cloudier in recent weeks, given the rate hikes. Should rates continue to climb as markets expect, it would have a dampening effect on demand. It would also require the bank to grow increasingly conservative with its underwriting.
“Looking forward, it’s far more difficult to gauge,” Maher said.
Money in the bank
It's also difficult to forecast how quickly deposit costs might rise. Depositors typically are slow to demand increases because it may mean switching banks, and making that change is a hassle. But Maher said that as the Fed’s benchmark rate marches from near zero at the start of 2022 toward 3% later this year, depositors may begin to move with haste in order to capitalize.
Matt Deines, president and CEO of the $1.9 billion-asset First Northwest Bancorp in Port Angeles, Washington, agreed.
“By the end of the third quarter, I think we are going to see pressure on deposit pricing,” Deines said in an interview.
Analysts at D.A. Davidson said in a report they expect another 175 basis points of rate increases this year.
“Consumers and commercial customers alike are likely to demand a ‘share of the wealth’ after years of low interest rates,” they said of looming pressure on deposit costs.
On the loan side, demand for home mortgages is already waning. Mortgage rates this summer are twice as high as a year earlier. When rates were low, home loans were a key source of income for banks with large mortgage operations. That is changing quickly.
Joel Kan, the Mortgage Bankers Association’s associate vice president of economic and industry forecasting, said mortgage refinance activity in late June was 80% lower than a year earlier and more than 60% below the historical average.
“Overall purchase activity has weakened in recent months due to the quick jump in mortgage rates, high home prices and growing economic uncertainty,” Kan said.
Maher said demand for residential construction loans has begun to ebb as well. He will watch for a slowdown in consumer and commercial spending in the fall — after summer vacations and travel — and the impact it may have on economic activity and broader loan demand.
“I think you may see a stronger pullback late in the third quarter and into the fourth,” Maher said.