The good news: the economy continues to strengthen. The bad news: the economy continues to strengthen.
For credit unions, a strong U.S. economy presents a double-edged sword-good jobs numbers means more people are willing to borrow money to purchase big-ticket items like houses and automobiles (credit unions' proverbial "bread and butter"); but a vibrant economy also suggests rising inflation and the need for the central bank to put on the brakes by tightening monetary policy through hiking short-term rates. Higher interest rates mean higher costs for credit unions, which eventually translates into lower net income.
All signs point to the Federal Reserve boosting the Fed Funds Rate sometime next year, after more than six unprecedented years of keeping such rates at near-zero levels. Among them:
- According to data from Meridian Alliance LLC, the national unemployment rate is projected to fall to 5.4% at the end of 2015 from 5.8% currently, and edge further down to 5.3% by year-end 2016. (The Fed defines a 5.5% jobless rate as equivalent to "full employment.")
- A recent Wall Street Journal survey suggests the current near-zero short-term rates could climb to 1.0% by end of 2015, then reach 2.2% by end of 2016.
- Meridian is predicting the yield on the 10-Year Treasury Note is expected to climb from 2.3% now to 3.2% by the end of 2015 and reach 3.6% by year-end 2016.
- The Fed hasn't boosted rates since the summer of 2006, when the short-term rate was at a relatively lofty 5.25%.
NCUA Chief Economist John Worth warned in a recent economic update video, a changing interest rate environment may prove "challenging" for many credit unions next year and beyond.
Of great concern is the rising gap between short-term and long-term rates—which would hurt CU's net interest margins.
"If the increase in short [term] rates is larger than the increase in long [term] rates—that is, if the yield curve becomes flatter—credit unions could likely see a narrowing of net interest margins," Worth said in the presentation.
With non-interest income already moving lower across the industry, a continued decline in net interest margins would lead to falling net income and even losses at some credit unions.
"The projected rising interest rate environment and the projected narrowing of the term-spread could pose challenges to credit unions," Worth added. "Especially vulnerable are those that have developed loan and deposit portfolios that are sustainable only in a falling or low-rate environment."
So, in the likely event that interest rates increase next year, how can credit unions best position themselves to protect their bottom lines?
Worth said credit unions must monitor their balance sheets in this type of rate environment. If and when rates spike, some credit unions should sell off deposits paying market interest rates, while credit unions holding too much fixed-rate and longer-term assets like fixed-rate mortgages might be in trouble, he said.
Brian Turner, president and executive director at Meridian Alliance, told Credit Union Journal that the best thing that a credit union could do in 2015 would be to "protect its liquidity profile."
"Most credit unions have adequate spreads between loan yields and cost of funds to support their current operations so a simple goal of reinvesting loan run-off at these expected higher marginal loan rates while building cash via investment run-off and share growth will help position credit union earnings through 2015," Turner said.
Indeed, if the short-term rate reaches as high as 1.35% by the end of next year (as a survey by the Fed itself currently forecasts), this could push consumer loan rates upward by as much as 40 or 50 bps.
"At the same time, the [credit union] industry's historical cost of funds shows a rate sensitivity of less than 10% to a 100 bp increase in [the] Fed Funds [rate]," Turner noted. "A strong liquidity profile will put less upward pressure on [the] cost of funds (assuming limited competition for funds), preserving historical rate sensitivity and enabling wider net interest margins during the rising rate environment—for a while."
In a rising-interest-rate climate, some credit unions are likely to consider unloading some of their longer-term investments. But Turner cautions that would depend upon the credit union's proportion of total earning assets and the relative yield-to-duration.
"Since fixed income assets are priced efficiently in the market, the credit union should determine whether the value lost by selling exceeds the expected income derived from the investment, or expected reinvestment to loans over the next two to three years," he indicated. "A higher expectation in loan growth could put less pressure on earnings by selling investments. Also, many expect investment durations between two and four years to have greater price volatility as opposed to higher-yielding seven- to 10-year investments as the yield curve flattens. This could have a strategic impact on the potential timing of any sale."
Moreover, Turner asserts that a sudden hike in the Fed Funds rate would actually benefit some credit unions because that would allow marginal asset yields (especially those with higher short-term funding profiles) to increase at a faster pace than cost of funds for a defined certain period of time.
"This assumes, of course, that historical rate sensitivity of non-term shares is retained, as I expect it will," he added, citing that the credit union industry continues to have a "very strong profile which puts less upward competitive price pressure on funds and provides most institutions with an opportunity to widen their net margins."
But it is also important to remember that credit unions have historically managed interest rate risks very well.
"Credit unions are run very conservatively take very little risk," Mike Schenk, VP-economics and statistics of CUNA told Credit Union Journal. "They are careful about exposure. I can't think of one credit union that failed due to interest rate risk issues."
Regardless of how quickly or how far the Fed pushes up short term rates, Worth advised credit unions to have a firm idea of how their income statements and balance sheets are affected by a rapid rise in short-term rates, "and they should have a plan for dealing with the potential consequences."