MUSKEGO, Wis.—Given that the Fed’s monetary policy has not been easy to predict, one analyst is encouraging credit unions to prepare now for rising rates but to also hedge their bets.
John Hickey, vice president of investments for Corporate Central Credit Union, is advising credit unions to begin offering above-market, fixed-rate CDs with a call option for three to five years to mitigate exposure in case rates don’t increase as expected.
“They will use those funds to capture as many floating-rate, and fixed- to floating-rate member loans—HELOCS, ARMS and credit cards—as possible,” Hickey explained. “This will also allow CUs to lock in an adequate interest margin that will widen if rates increase.”
Gradual Rate Increase
Hickey suggested that the Fed’s actions in recent years indicate that it will test the waters slowly with rate increases (see related story here).
“The Fed in 2012 said they may begin tightening when unemployment dropped to around 6.5%, but it has continued to keep rates low even as the unemployment rate has fallen to less than 5.5%, a rate that some economists characterize as full employment,” said Hickey. “During that same period the Fed said they may begin tightening when inflation either reaches or exceeds 2% as measured by the core personal consumption expenditure (PCE), which excludes food and energy.”
Hickey noted that PCE has remained consistently below 2% and has given the Fed an excuse to continue delaying a rate increase.
“Late in 2014 the Fed exercised a ‘half’ measure and announced the end of Quantitative Easing, but stipulated they would reinvest the maturities until a date to be named later,” recalled Hickey. “The market appears to have absorbed that action as rates have hardly moved at all since then. I believe another ‘half’ measure in the form of a modest rate increase is in our near future. If nothing else it will allow the Fed to observe the market reaction and gauge if more aggressive rate action is warranted or if loose monetary policy will persist.”
For his part, Hickey believes rates will begin to rise gradually in the fourth quarter.
“The Fed has changed the terminology recently and has avoided the word ‘tightening’ and used ‘normalization’ instead. That leads me to believe this will be a slower, more methodical process than previous rising-rate interest rate cycles,” he said.
Hickey said that credit unions did well to capture consumer loan market share from the big banks during the financial crisis and are well-positioned to provide liquidity during the economic recovery.
“A direct consumer loan that performs will yield more than an investment and provide wider net interest margins,” Hickey reminded. “At the risk of overstating the obvious, maintaining the loan portfolios captured during the crisis is key to continued success.”
Margins Get Bigger
Hickey reiterated that CU margins should widen when rates go up.
“Since the financial crisis many in the banking industry have been compelled to tolerate low interest margins from low returns from their investment portfolio while they focused on deleveraging their balance sheets,” he said. “Meanwhile, there has been significant improvement in loan demand and charge-offs have returned to manageable levels. Credit unions would be wise to acknowledge that the recent absence of competition is no small factor in attaining market share in consumer loans resulting in higher net interest margins. Overall, I think their margins will be improved for those who maintained discipline in the previous two years.”
Hickey said Corporate Central has been positioned for rising rates for some time and already holds a significant portion of its balance sheet in floating-rate assets.
“If and when the Fed announces interest rate increases, we expect to see the yield curve flatten,” said Hickey. “When that happens we will be positioned to increase our dividends for short-term investments faster than our competitors while maintaining strong margins.”