Capital Advisors Group published a research brief entitled, "Deposit Betas Rising but Still Falling Short," which discusses how bank deposit rates have lagged money fund and market rates since the Fed began hiking rates 2 1/2 years ago. Author Lance Pan writes, "After almost a decade of near-zero investment returns, liquidity investors are beginning to reap the benefits of higher rates. This is true for investments in capital markets, where rates have risen along with the Federal Reserve's actions. On the other hand, depositors may need to wait a bit longer -- a lot longer if banks have their way." (Note: The Federal Reserve is expected to raise short-term interest rates for the 7th time since December 2015 today. Watch for details tomorrow and watch for money fund rates to rise again in the coming weeks.)

CAG's Pan tells us, "We wrote last August about how deposit rates have failed to keep pace with rising short-term interest rates. The benchmark fed funds rate has risen another 50 basis points (bps, or 0.50%) since then, while the national average money market account (MMA) rate has increased just 5 bps. This results in a 'deposit beta' of 10% (change in deposit rate over change in benchmark rate) for the period."

He explains, "While deposit betas have been stubbornly low in recent quarters, all hopes are not lost. Transcripts from recent earnings calls at several of the largest regional banks indicate that betas may move materially higher soon. In this month's report, we provide another update on the state of deposit rates, with a sample of deposit betas among major US banks. Additionally, we end with a suggestion for liquidity investors to look to capital markets for yield opportunity."

Capital Advisors' piece continues, "Businesses have used deposit accounts to manage liquidity for as long as the modern banking system has existed. Starting in the mid-1990s, money market mutual funds (MMFs) gained popularity among institutional liquidity accounts as a preferred cash management tool. For a brief period around the 2008 financial crisis, MMF balances surpassed deposits. The crisis and ensuing regulatory issues resulted in stagnant MMF balances while deposits surged.... At the end of 2017, total deposit and currency balances at 'nonfinancial corporate businesses' stood at $1.5 trillion, while MMF shares held by the same entities totaled $472 billion, for a ratio of roughly 3:1."

It goes on to say, "Higher deposits immediately after the financial crisis were attributed to the extraordinary government measure of deposit guarantees. Regulatory scrutiny into MMFs in later years left major institutions with few alternatives other than deposits for liquidity management."

The piece adds, "To conclude, despite the 1.50% rise in the fed funds rate over the last 28 months, money market and short-term CD rates have barely budged. Historically, these rates tended to rise with the policy rate, sometimes exceeding benchmark increases. In contrast, short-term market-based rates rose along with FFR in all three periods by about the same magnitude."

It also comments, "In our August 2017 research piece, we discussed several possible causes for banks' muted reaction to rate increases in this current cycle. We reproduce the summary in bullet form: Abundant reserves: Banks have more deposits than they need; Restrictive regulations: The costs of holding deposits have increased; Banks keeping the first cut: Banks want to pay themselves before depositors; Investor inertia: They have not adjusted expectations after a long period of yield drought; and, MMF reform: A natural market-based substitute is not as attractive now."

Pan asks, "Are higher deposit rates in sight? Are banks simply delaying an increase or will they pay below-market rates on deposits permanently?" He answers, "Based on information obtained from bank executives and investors, we expect banks to raise deposit rates more rapidly this year, although the increases are likely to remain less competitive than market rates until reserves are drained sufficiently, and lending picks up substantially. We were able to get some confirmation of this from transcripts of senior bank executives at first quarter 2018 earnings conferences."

The paper concludes, "It is undisputable that banks have not rewarded their depositors sufficiently as rates move higher. With improved profitability, friendlier regulatory treatment of deposits and a smaller Fed balance sheet, one would expect demand for deposits to rise, which would in turn lead to higher betas. Both anecdotal and empirical evidence point to the validity of this line of thinking. However ... deposit betas in the current cycle have a long way to climb to reach their historical averages."

Finally, they state, "We cannot end this commentary without addressing the credit risk associated with deposits. In the institutional context, most deposit balances are in excess of the FDIC's deposit insurance level. Thus, investors must evaluate the risk of being exposed to a limited number of bank counterparties versus a diversified portfolio of names with similar credit characteristics, or even non-bank corporate credits. In short, depositors may need to wait a while longer for materially higher rates unless they are willing to consider market-based instruments. There, several options may exist to suit their liquidity and credit needs."

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