Credit unions are looking at the plateau in interest rates and wondering-as are their members-is it time to cash out?
The Credit Union Journal asked several corporate credit union investment experts if cash is still king or if it has peaked, and what their member credit unions need to be doing.
Interest rates have plateaued or even declined slightly since the Federal Reserve Board halted its rate-raising campaign in August, leading three corporate credit union investment experts to tell The CU Journal that the time is now for credit unions to review their portfolios to prepare for a possible change in 2007.
Brian Turner, manager of advisory services for Southwest Corporate, headquartered here, summarized our panel's recommendations: "There is a big challenge for credit unions. If there is a perception rates will go down next year, they can't stay in cash," he said. "We've been counseling credit unions to have a strategy that keeps current earnings opportunities in place, while keeping an eye on the future."
The three keys, Turner said, are for CUs to have liquidity today to take advantage of current overnight rates, have sufficient money on hand to offer to members for loans, and "at the same time, they must have longer-term structures as well."
Turner, along with Ron Araujo, San Dimas, Calif.-based WesCorp's vice president of investment strategies and education, and Greg Wirthmann, senior vice president and chief investment officer for Southeast Corporate in Tallahassee, Fla., agreed most indicators point to a potential interest rate cut by The Fed some time in early 2007 to reenergize a slowing U.S. economy. However, the panel cautioned, a drop in rates is not set in stone if inflationary pressures continue or if the dollar needs backing if/when foreign central banks raise their rates.
Assessed Araujo: "The story about the rate decline has been catching on, but it has been in WesCorp's forecast for some time now. We are predicting a cut in 2007 because the economy is slowing down-the recent GDP report was only 1.6% growth, and although that number often is revised, auto production was very low."
The problem, according to Araujo, is "the market doesn't have any real leadership right now. It could be because [Fed Chairman Ben] Bernanke has only been in for nine months. There is uncertainty regarding the Fed and the Fed's reaction."
There have been a slew of conflicting economic reports and interest rate predictions in recent weeks, our panelists noted. The non-farm jobs creation number for October was 93,000, but the August and September jobs numbers were revised upward sharply. The payroll numbers, combined with a recent government release citing rising wages, caused some on Wall Street to predict the Fed would raise rates to combat inflation. At the same time, the low third quarter GDP report prompted others to call for the Fed to cut rates.
Those two predictions came days apart.
"There is an awful lot of volatility in the marketplace due to speculation as to what the Fed will do," said Southwest's Turner. "Employment and productivity are causing volatility. The goal of the Fed is to create long-term economic stimulus without upward inflationary pressures. Right now, the Fed is taking a wait-and-see approach what effect the slowing economy will have on inflation. Some feel the tightening campaign might have gone up too fast."
Rate Cut Coming Soon?
Rate cuts? Rate Increases? What is reality? Southeast's Wirthmann said history points to a cut in the spring.
"The Federal Reserve has completed its tightening cycle and won't increase again," Wirthmann predicted. "Over the last 19 years, the first easing occurs approximately 7.4 months after the last tightening. If historical precedent continues, the first rate cut will be in the late first quarter or early second quarter of 2007."
"Having said that, the treasury curve has gotten ahead of itself," he added. "The two-year treasury rate infers there will be at least three easings."
Southwest's Turner said if short-term rates decline next year, it is anticipated the rate and level of the cuts will not be anywhere near the same as the generational low levels the Federal Funds Rate reached in 2000-01. "We probably will see a cut of about 50 basis points, if rates decline at all."
Said WesCorp's Araujo: "The revised job creation numbers indicate more strength in the economy than thought to be in place. We tell credit unions there are two sides to the balance sheet: they must balance assets and liabilities. Whatever the credit union's target is from a risk standpoint, don't play the rate guessing game-factors are personal and internal."
If a CU is planning to lend heavily, Araujo explained, it should stay short, regardless of where it thinks rates are going. On the other hand, "If a credit union is not expecting change in its lending portfolio, and believes, as we do, rates are going to decline, it is not a bad time to go out longer. Staying short could go back on the credit union in early 2007 if rates decline."
"We encourage credit unions to have a dialog with their investment vendor about their specific situation," he added.
Rate Increase in 2008?
Southwest's Turner said even if interest rates decline in 2007, it is predicted they will rise again the following year.
"So how far out should credit unions go? Not five or six years if they anticipate rates rising in 2008," he declared.
CUs should look at an investment ladder of two-to-three years, perhaps 3.5 years, Turner recommended. "This requires a leap of faith by credit union managers," he acknowledged, "because the two- or three-year term rates today are a little bit less than, or the same as, current overnight rates. But, this is necessary in case overnight rates drop in 2007."
As rates go down, there will be an increased demand for consumer loans, Turner added, so credit unions need to maintain liquidity. "When investing, they can't tie up too much cash. The type of investment is important, also. We would discourage the use of callable investments and lean towards less optionality, unless they have extended lockout provisions."
Southeast's Wirthmann said CUs should maintain a "disciplined" strategy and "maintain that strategy through peaks and valleys."
"We think the fourth quarter will be better than the third quarter in economic performance. The decline in oil prices will put more funds in consumers' pockets again. But, savings rates are down and consumer debt is at an all-time high, and real estate is slowing down, if not declining in value."
Given all these circumstances, Wirthmann said a "basic ladder" makes sense for CUs. He said this reduces interest rate risk because the credit union continually gets cash back. If rates are rising, the CU can reinvest at higher rates. Or, the regular liquidity funds loan demand if it picks up. If rates decline "the credit union still should have some longer certificates at the end of the ladder."
"We are cautioning credit unions not to buy unstructured mortgage products," Wirthmann added.
Window Certificates
According to Araujo, WesCorp has developed a variable-term "window" certificate. He said CUs can choose the maturity date within a variable period.
"This is a new product that we have not seen offered before, and it is drawing a lot of interest," he said. "If a credit union wants to invest for 18 months, the window certificate will mature in 15 to 18 months, and the credit union doesn't have to say when now. It can decide on a three-day turnaround."
Araujo said the window certificates help CUs that don't want to wait to invest, but still need liquidity. He said it is helpful for teachers' credit unions that experience drawdowns in the summertime, as they can designate a window of six-to-nine months.
"The credit unions can choose the window, and there is not a huge distinction in the yield curve. They have to be very tactical in the program and not worry so much about the term."
The bottom line, Araujo emphasized, is not sitting on cash.
"Some credit unions are seeing their lending pipeline dwindle. There is not much real estate activity, and even the auto side is quiet," he said. "Credit unions don't want to have a large investment portfolio, but they want the money to go to use somewhere."
