As we all experienced, lockdowns starting in March of 2020 to contain the COVID-19 pandemic sent shockwaves through the financial markets, causing individuals and corporations to grapple with economic uncertainty. Over the course of 2020 and 2021, many individuals and businesses increased their savings and bank deposits as a precautionary measure. During the first half of 2020, commercial bank deposits increased by a record-setting 37% due in large part to Paycheck Protection Program (PPP) loans, nonfinancial companies drawing down their lines of credit, near-zero interest rates, and consumers’ general inability and unwillingness to spend money. However, bank analysts have dramatically cut their expectations for deposit levels at the largest banks over the past few months, now anticipating a 6% decline in deposits this year after forecasting a 3% increase just months ago.*
Rapid Rate Increases Expected for 2022
So why the dramatic change in course? In response to rising inflation that now exceeds 8%, forecasts from both economists and Fed officials call for dramatic and rapid increases to the Fed’s core interest rate over the next year and beyond. With two rate hikes for a total of 75 bps so far this year, an untraditional and somewhat unpredictable Fed tightening cycle is well underway, resulting in the opportunity for local governments to seek higher yields on their investments than banks are currently willing or able to offer.
The dramatic influx of bank deposits over the past two years has banks nearing regulatory limits on capital. Because many banks were unable to put the deposits to use in the form of loans during the pandemic, they had already begun limiting bank deposits before the Fed’s change in course. According to Barclays analysts and the Wall Street Journal, the industry has $8.5 trillion more in deposits than loans so not only do the banks not want new deposits, they are actively looking to offload existing bank deposits to bring their totals more in line with loan demand.
Optimal Time to Move Excess Bank Deposits to Michigan CLASS
As the Fed moves rates at a faster-than-normal pace, local government investors are well-positioned to take advantage of increasing rates, especially in high-quality short-term investment vehicles like money market funds and AAA-rated local government investment pools (LGIP). Given the short average maturity of pool investments, LGIP yields typically adjust rapidly and provide a current market rate, closely mirroring the effective Fed Funds Rate.
As holdings in an LGIP mature, fund managers will have the opportunity to reinvest the proceeds into higher-yielding securities thus providing investors with a more current (and higher) market rate. For example, daily yields for Michigan CLASS have increased over 30 bps since the last rate hike on May 4, a clear reason to consider moving funds now. Conversely, bank deposit interest rates are unlikely to move substantially until loan demand and deposit levels return to normal.
If you’d like to set up a meeting to analyze your current investment program or for more information on how to best navigate your investment portfolio in a rising rate environment, please fill out the below form to schedule a meeting with the Michigan CLASS Relationship Team!
*Source: Wall Street Journal. Graph sources: FDIC, Federal Reserve Economic Data, & Public Trust Advisors, LLC. Many factors affect performance including changes in market conditions and interest rates and in response to other economic, political, or financial developments. Investment involves risk including the possible loss of principal. No assurance can be given that the performance objectives of a given strategy will be achieved. This is an example of a prior rising rate environment and may not be an accurate depiction of a future rising rate environment. Past performance is no guarantee of future results. Any financial and/or investment decision may incur losses. All comments and discussion presented are purely based on opinion and assumptions, not fact, and these assumptions may or may not be correct based on foreseen and unforeseen events.