This Month’s Chart Deck
The case for a rate cut next month remains unclear after this month’s inflation data. The real effective Fed funds rate (Slide 1), based on the nominal Fed funds rate less the Personal Consumption Expenditure (PCE) inflation rate, is still above the historical average going back to January 2000, and suggests that the overnight rate is still too restrictive. However, inflation remains an unpredictable variable, and several Fed officials still sound cautious. They may be leaning to delay rate cuts until next year until they can see more evidence that it is getting back to the 2% target range.
Even if the Fed cuts the Fed funds rate in the fall, there is no guarantee that this will help bank treasurers who still contend with deeply underwater bond portfolios, including both bonds in held-to-maturity (HTM) and available-for-sale (AFS). The fair value (FV) of their total portfolio remained at $0.5 trillion below their amortized cost (AC) (Slide 2) at the end of the last quarter, 100% of which were in their mortgage-backed securities (MBS) books (Slide 3). Total unrealized losses for HTM and AFS fell from 25% of Tier 1 capital at the end of 2022 to 20% last quarter (Slide 4), attributable to run-off in Treasurys. Banks also have less exposure to bonds. At the end of 2022, their investment portfolio equaled 24% of total assets, which they reduced to 20% at the end of Q2 2025 (Slide 5).
Despite the underwater bond portfolio’s heavy drag on their interest income, the industry continued to widen net interest margins (NIM) in the last two years (Slide 6), which on average reached 3.7% in Q2 2025 according to data collected by the Federal Financial Institutions Examination Council (FFIEC). NIMs have not been this wide since the onset of the pandemic, and are up from 3%, a 25-year low, in Q1 2022.
Even as the industry has been repricing its time deposits lower all year, depositors continue to roll and add cash to their accounts. Total assets funded with time deposits maturing in less than one year increased from 12% in 2022 to 22% this last quarter, a 13-year high (Slide 7). Demand deposits as a percent of total deposits, at 25%, is unchanged over the previous four quarters, a remarkable streak compared to its history over the past 25 years (Slide 8) which has been more volatile. As their deposit funding pressures eased in the last year, bank treasurers let some of their short-term borrowings from the Federal Home Loan Banks run off, but that trend seems to have flattened out in Q2 2025 (Slide 9). Finally, bank treasury hedging activity, measured by the notional principal of interest rate swaps not used for hedging (Slide 10), continued to increase last quarter.
Real Rates Head Lower As Inflation Edges Up
No Relief In Sight For Underwater Bond Portfolios
MBS Accounts For All The Pain
Capital Exposure Improving But Still Massive
Asset Mix Continues Tilting Away From Bonds
Net Interest Margin Back To Pre-Pandemic Level
Depositors Continue Adding Time Deposits
Demand Deposit Trends Flatten
Borrowings May Have Found A Floor
Hedging Activity Up In Q2 2025
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Ethan M. Heisler, CFA
Editor-in-Chief