Don't Fear a Taper Tango

Banks Know the Fed’s Steps

29 September 2021
5 Minute Read

The US Federal Reserve will soon slow its open market purchases of fixed-income securities. These purchases have served to keep rates low and liquidity flowing, but as the post-pandemic economy heals, it’s time for the Fed to taper. As they step back from buying, who is going to step forward?

One thing we know is that history won’t repeat itself. In 2013, then Fed Chairman Ben Bernanke alluded to the possibility of the Fed tapering bond purchases, and the market threw a taper tantrum. Rates on the 10-year Treasury jumped from 2% to 3%, only to fall back once the actual tapering began six months later.

We think it’s different this time. Rather than a tantrum, we believe there will be some give and take when the Fed steps back, more like a taper tango. That’s because, even as the Fed steps back from the bond market, US banks are likely to increase their bond investments.

Banks Need Income

Banks are in a challenging situation. Interest rates are low, loan growth is weak, and deposits are high. A crucial measure of available funding, US banks’ loan-to-deposit ratio is the lowest in 50 years (Display).

US Banks: Too Much Cash, Too Few Loans
A line graph of the loan-to-deposit ratio for US banks. Peaks at almost 100% in 2000, currently at 60%.

Current analysis does not guarantee future results.
As of June 30, 2021
Source: US Federal Reserve

To offset the eroded net interest income, banks can invest their excess funding in securities. At the time of purchase, the bank denotes securities as either shorter-term positions or held to maturity (HTM). Those designated HTM remain on the balance sheet at the amortized acquisition cost until they mature, helping banks manage capital volatility and increase resiliency in stress tests.

The amount of HTM securities on bank balance sheets has more than doubled since the beginning of 2020, a sign that banks expect excess deposits to remain on their books for some time. Cash has also continued to build as banks wait to invest until rates rise (Display), either via the taper or through market forces.

Fiscal Stimulus and Quantitative Easing Have Changed US Bank Balance Sheets
Left shows increase of assets, cash, deposits over 18 months. Right graph maps cash, loans and securities over 10 years.

Current analyses do not guarantee future results.
As of June 30, 2021
Source: US Federal Reserve and AllianceBernstein (AB)

Part of the problem is that corporations haven’t made capital investments during the pandemic, limiting commercial and industrial loan demand. Banks say they’re optimistic about the post-pandemic economy as trends and economic activity appear robust compared to 2019. The only current concerns are lagging spending on travel and entertainment, though there are also some short-term supply-chain bottlenecks and inventory constraints to overcome. For these reasons, we believe the loan growth malaise is temporary.

In addition, much of the government stimulus sent to consumers has ended up in the bank. Consumers’ spending patterns have improved over the past 12 months, but they’ve also paid down loans and credit cards, further depressing loans outstanding.

Not only have loans decreased for the time being, but regulatory changes have increased the liquidity that banks need to have on hand and manage efficiently. Banks that might have loaned out over 90% of deposits in the past are aiming for a level closer to 75% today. But the industry isn’t even hitting this new, lower target. The industry’s loan-to-deposit ratio is currently at 60%, and one of the four largest banks is at a miserable 45%. That means there is a lot of capital on bank balance sheets just waiting to be invested.

In fact, we believe that excess funding is over $2.5 trillion. To fully deploy that much excess funding into loans could take more than four years, assuming loan growth returns to pre-pandemic levels of 3% to 4% annually. That’s at least four years or more that banks will be buying an elevated level of securities in the open market.

Learning From Japan’s History

Some investors have expressed concern that the US’s current low loan-to-deposit ratio might be forewarning economic duldrums because it mirrors the move Japan’s ratio made in the 1990s (Display).

Japan: Two Meaningful Loan-to-Deposit Drawdowns, Two Experiences
A 40-year plot of loan-to-deposit for all Japanese banks and mega banks. Drawdowns 1995-2005 and 2014 to today.

Current analysis does not guarantee future results.
As of June 30, 2021
Source: Bank of Japan and AllianceBernstein (AB)

The 1990s became known as Japan’s Lost Decade when its economy stalled, something the US wants to avoid. However, at that time Japan had more significant issues than a falling loan-to-deposit ratio: it was also dealing with an aging population, low birth rate, stagnant growth and low efficiency, amid Japan’s post-bubble deleveraging cycle. None of those are critical concerns in the US today.

Japan’s loan-to-deposit ratio began to fall again in the mid 2010s—an experience we believe is more relevant to the US today. This time, the decline was due to qualitative and quantitative easing. Japan’s economy was recovering thanks to then Prime Minister Shinzo Abe’s economic plan, and credit growth was stable at 2% to 3%. With rates meager or even slightly negative, Japanese banks needed to offset low net interest margin. Constrained by regulation, they invested in the safest assets they could find: both domestic and global government and agency bonds.

As the Fed begins tapering, we believe US banks will fill the void—purchasing bonds to invest excess capital and supplement struggling net interest margins. And even though US banks can venture beyond government bonds, we expect their primary investment target to be high-quality Treasuries and agency bonds.

The decrease of the US bank loan-to-deposit ratio has been pronounced, but based on pandemic-induced fiscal spending rather than more harmful socio-economic circumstances. While the Fed tapers and bank loan growth normalizes over the next four or five years, albeit in fits and starts, we believe US banks investing excess capital will step into the open market in the Fed’s place.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.


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