Listen to your balance sheet, not the markets

Avoid speculation and overreaction to swings in market rates by answering these four questions in your interest rate risk analysis.

On May 3, Jerome Powell and the Federal Open Markets Committee announced yet another fed funds rate hike (25 basis points). This marks the 11th consecutive rate hike since March 2022, totaling 500bps over the course of 14 months. The more noteworthy observation is that the FOMC decided on this rate increase after several larger regional bank failures and widespread fears of a crisis in the banking industry. This action and public comments from Fed officials send a clear message to the markets: FOMC monetary policy bias will remain hawkish against inflation. In short, they plan to keep the funds rate high and even may increase it further.

Meanwhile, the bond market has priced US Treasury bonds higher, creating an inversion in the yield curve. The negative spread/slope between two-year USTs and 10-year USTs is at a level that hasn’t been witnessed since the 1980s, the last time inflation was viewed as problematic for the economy. The fed funds futures market is pricing a FOMC rate cut in July and over 200bps of rate cuts over the next 12 months. This is important because it suggests the widespread market anticipates short term rates will soon be significantly lower than observed today.

Don’t overreact to rate changes

There are strong and valid arguments to be made for both viewpoints on the economy and market rate outlook. This creates quite a dilemma for credit union risk managers. Net interest margins have been narrowing, considerably so during Q4 2022 and Q1 2023, and are expected to narrow further over the next few quarters as deposits become more expensive and overall funding compositions shift to be more highly weighted in CDs and wholesale funding. A strategy influenced by FOMC messaging (i.e., expectations for higher rates for longer) would include longer funding maturities and shorter asset durations. This could be painful if market rates do fall as the broad marketplace forecasts. A strategy influenced by the broad market outlook for falling rate conditions would involve adding fixed rate assets at yields that are very tight (or negative) spreads to short-term funding costs. This would worsen margin conditions that are already stressed and leave credit unions more vulnerable to Fed rate increases.


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