The Days of Huge Fed Rate Hikes Are Over

Despite the disappointing jobs numbers reported Friday, Federal Reserve Board Chair Janet Yellen made clear in comments last week that a rate hike is coming. While the slowdown in hiring reported for May reduces the likelihood of an immediate rise in rates, it is still a question of when — not if — rates will go up.

But before banks place their bets on higher interest-related revenue, let's try to put the prospect of a rate hike in perspective. This is still not Alan Greenspan's Federal Reserve.

In Greenspan's days — which saw factors supporting a more traditional Fed rate cycle — it was not uncommon to see the federal funds rate approach 6% and 10-year rates even higher. But those days are long gone. The outlook for U.S. growth and inflation has changed so fundamentally in the last decade that most U.S. rates — from fed funds out to 10-year notes and beyond — look likely to run between 2% and 3% for the next decade. Banks waiting to get rescued by a Greenspan cycle may end up bitterly disappointed or even out of business.

Today we are in the middle of a productivity devolution. U.S. workers from 1995 to 2004 on average raised output by an extraordinary 3.25% a year, a trend that would double standards of living every 22 years. But average annual productivity growth from 2004 to 2014 slipped to 1.5% and, in the last five years, to 0.5%, a pace that would double living standards only every 139 years. Since growth depends on rising population, productivity or both, the productivity devolution has hurt.

The productivity downshift has come for reasons ranging from a changing workforce to declining gains from technology to increasing regulation and beyond. The Fed has acknowledged these challenges. None look likely to change soon.

The world also is awash in influences likely to keep inflation low. From the underemployed in the U.S., to the unemployed in the E.U., to the uncertain economies in China and Japan, producers of anything that gets shipped around the world have very little pricing power.

Yellen and her colleagues have much less room to operate than Greenspan did. Pushing rates above the pace of growth and inflation is eventually a recipe for recession. The Fed has to move slowly and not very far.

That doesn't rule out higher rates if state or federal governments light the fuse on productivity and growth by investing in infrastructure or education. Rates could rise too if the Fed has to quickly exit its portfolio of securities built from its "quantitative easing" policy. But the chances of either of those scenarios accelerating overall growth are remote. Therefore, the odds of sharply higher rates look low for now.

Low rates put banks in a bind that should be obvious by now from the last few years of financial results. Fixed loans and securities roll over into lower rates. Cash weighs on earnings. Returns from interest rate risk and other exposures get compressed. Net interest income and return on assets fall.

With banks' cost of funds now almost as low as it can go and most banks focused on cutting expenses, the asset side of the balance sheet has become more important than ever. Banks need to raise returns on cash and reduce reinvestment risk.

Sitting in cash continues to extract a heavy price, especially since other assets offer good return for marginally higher credit and liquidity risk. Floating-rate securities well suited to banks pay anywhere from 25 basis points to as much as 95 basis points more than cash at the Fed.

The latest annual report from the Treasury's Office of Financial Research warns about the risk of extending asset duration, but investors can extend duration as long as they counter with a rising pool of floating-rate assets. This mix of floating-rate and longer fixed-rate assets stands to do better than the usual diet of intermediate or callable agency debt.

Banks also have more providers entering the market for bank loans. These new entrants help screen and re-underwrite loans that other banks can originate but cannot take into portfolio. Those loans a decade ago would have gone into securitizations, but the cost and regulation of private securitization have made that channel less efficient. The bank-to-bank market for student loans and mortgages that don't fit agency guidelines has started to grow, and survivors should pay attention.

It may be cold comfort to know that banks waiting for higher rates have good company, including the Fed. The Fed's own projected path of rates has come down consistently over the last few years as growth has disappointed and as inflation has continued to run below target. Fed expectations will likely come down even further in the months ahead.

Steven Abrahams is the co-founder of Milepost Capital Management and former head of securitization research for Deutsche Bank.