Do you feel like you’ve just gotten used to rates increasing from their historic lows and now talk of rates declining is making your head spin a little? Yes, rates may be declining sooner than expected. Although no one can predict rate changes with any certainty, the increasing probability should be moving the topic of declining rates higher up on the agenda at your board and ALCO meetings.
The position of the Feds, the fed funds futures market, and the spread between the 3-month Treasury bill and the 10-year Treasury note all point to an increased probability of the Feds reducing rates, and it could happen sooner than you might think, maybe even as early as Sept 2019.
What implications does that have for your credit union’s balance sheet? If you’re putting variable rate loans on your books, are appropriate floors set? Does it change your strategy in the mix of fixed versus variable rate loans?
What about your investment strategy? Pay close attention to the probability of calls for investments with that option. If you hold CMOs, understanding the change in yield and potential cash flow in multiple down rate scenarios will be important as you evaluate how to manage your portfolio if market rates decline.
On the liability side, if you’ve been chasing liquidity to fund loan demand, how might your strategy change regarding things like CD specials? Should terms offered be shortened to account for a potential downturn in rates? Is your board willing to reduce rates, on non-maturity shares? During the last downturn in rates, many credit union boards were hesitant to lower dividend rates below a perceived “never-to-go-below” floor. When margins declined enough to affect ongoing operations or capital levels, the only alternative was to lower dividend rates significantly. For those credit unions that have not raised dividends much in the last year, your option of lowering rates if interest income starts to decline will be limited. Prepare to be proactive if rates decline again and devise a plan if interest income starts to decline. The low rate sensitivity in most non-maturity share accounts affords you room to offset declining asset yields.
For your ALCOs and management teams, what does a declining rate environment require from an Interest Rate Risk modeling perspective? First, I’d make sure that at least one down rate scenario is reviewed and documented in your ALCO minutes.
From a data perspective, make sure your modeler has appropriate floors set for your loans. Remember, even for fixed-rate loans, there is a floor below which you should be unwilling to offer new loans to ensure you cover the costs associated with the loan. Do you know what those “floors” should be for each of your loan types? Also, are repricing assumptions in the down rate reasonable, especially for any mortgages you have in your portfolio?
When modeling investments, make sure calls are implemented at appropriate rate changes and, as mentioned above, review assumptions for changes in cash flow for mortgage-backed securities.
For non-maturity shares, one of the biggest variables impacting interest rate risk analysis is the beta. Are your betas in a down rate environment appropriate? If you have to offer higher rates to maintain liquidity, you may need to use lower betas compared to a credit union that could afford to see some share run-off. Is your liquidity position changing such that you should either adjust your betas or at least run an alternative scenario to match your pricing strategy in a down rate environment?
Lots to think about as we anticipate where short-term rates are going and how they might impact financial performance next year and on into the future.