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Morningstar | Fed Maintains Policy Rate, Dot Plot Becomes Increasingly Dovish, Yield Curve Flattens Even More

As we highlighted in our last note, the Federal Reserve is no longer in any rush to raise rates. The Federal Open Market Committee voted to maintain its target rate range at 2.25%-2.5% in its second official meeting of 2019. The vote was unanimous. All things considered, we did not see any real surprises in the latest release, although the dot plot did become perhaps as dovish as possible. There were fewer changes to the language of the current release compared with the last release. The Fed emphasized that recent indicators point to slower growth for household spending and business fixed investment, but otherwise the language was essentially the same. We have maintained our underlying rate hike assumptions for our U.S. banking coverage, which includes no rate hikes in 2019, and only a single hike in mid-2020. CME futures data continues to point to no rate hikes in 2019, as does the Fed's dot plot.

The Fed released new economic projections and a new dot plot. Compared with the December release, the longer run economic estimates were largely unchanged, however, the federal reserve members are now expecting slightly lower GDP growth in the short term as well as slightly higher unemployment levels. The dot plot, as expected, showed a significant downward revising for the expected rate hike outlook over the next three years, however, the longer-term expected rate was unchanged at 2.8%. In the meantime, it looks like even the FOMC is now expecting no rate hikes in 2019, potentially one hike in 2020, and potentially one more sometime thereafter. This is the first time in a long time that the Fed and futures data are in agreement.

We expect some marginal net interest margin expansion in 2019 as the series of rate hikes in 2018 will have a full-year effect in 2019, however, after 2019 we expect the NIM lever to largely be over for most banks. With the 10-year yield diving, this will have some effect on NIMs, however, we will remind investors that essentially all of the banks under our coverage are more sensitive to the short end of the curve. So while the flattening yield curve is not a positive, it’s also not going to crush bank NIMs, either.

The Fed also weighed in with more detail regarding the shrinking of its balance sheet. As expected, the Fed is set to begin decreasing the amount of securities it is letting roll off, and it expects it could be close to what it now views as a normalized balance sheet size by as soon as September. For those interested in more technical details, the treasury monthly cap was changed from $30 billion to $15 billion, while the MBS cap was kept at $20 billion. However, the MBS cap now works differently. Instead of a roll off of up to $20 billion, now, up to $20 billion will be reinvested back into Treasuries, shifting the portfolio out of the longer duration MBS.

For a more detailed view of our expectations regarding interest rates and their effects on banking profitability, please see our December 2018 Observer, "The Return of the Bank: Net Interest Margins Reach a Turning Point--Funding Advantages and Net Interest Income."