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What to Watch for as QE3 Winds Down
Tuesday, July 2, 2013 8:35 AM

Federal Reserve Chairman Ben Bernanke indicated in late June that the Fed’s quantitative easing program may come to an end as early as mid-2014. The Fed believes the economy is expanding strongly enough to begin scaling back on its $85 billion in monthly mortgage bond purchases.

“The (Federal Reserve’s) committee currently anticipates that it will be appropriate to moderate the monthly pace of purchases later this year, and if the subsequent data remain broadly aligned with our current expectations for the economy, we will continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year,” Bernanke said.

What impact will this slower infusion of stimulus have on the economy?

“As the Fed slows down its purchases and even begins selling bonds they hold, bond prices will have to come down to meet the level of demand,” said Mark DeBree, Catalyst Strategic Solutions’ director of ALM Analysis. “And when prices go down, yields go up, and interest rates will follow.”

Is the U.S. economy strong enough to absorb the shock of rising interest rates?

“It’s doing better, but most experts say it’s still very fragile,” DeBree said. According to DeBree, a slowing of the bond-buying stimulus could impact credit union earnings, loan demand, deposits and levels of interest rate risk.

“If interest rates go up and the economy is strong enough to absorb the shock, consumers will continue to spend,” DeBree said. “But if the economy is as fragile as it appears, it could contract.”

“We’re looking at an environment in which loan growth is improving, but not significantly. A rise in interest rates would make the cost of borrowing higher. Mortgage rates are on the rise, and prepayments are already slowing down. This has been an examiner concern, since mortgages typically represent credit unions’ largest loans and generally have the longest repayment horizons. As rates rise, we can expect to see the average lives of mortgages held on the balance sheet extend out further,” he said.

For credit unions that hold large mortgage portfolios, slowing prepayment speeds and resulting longer average lives will reduce the level of asset reinvestment, because cash flows coming in each month will be less.

DeBree said that credit unions can expect pressure to raise dividend and certificate rates to accompany increasing interest rates, which will reduce earnings growth. Overall, the Fed’s transition away from quantitative easing will likely impact credit unions in four main areas:

  • Tightening of liquidity, because mortgage prepayments will slow and funds may begin leaving the credit unions
  • Narrowing gross margins as asset yields will be slow to move up
  • Pressure to raise funding costs along in response to rising interest rates
  • Rising levels of interest rate risk exposure

“This is the scenario that many have been talking about for a while, but now signs are visible on the horizon,” DeBree said.

What should credit unions do? Because exact timing of the Fed’s actions is unknown, DeBree said credit unions should be proactive in reviewing their balance sheet compositions and be selective in choosing products to add. Overall, credit unions need to understand their risk exposures and create a plan to position both sides of the balance sheet for a more dynamic interest rate and market environment.