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Withdrawing from "Monetary Cocaine" - Rising Rates or False Alarm?
Tuesday, September 17, 2013 6:55 AM

Interest rates have been rising, and the value of credit union bond portfolios has been falling. But people have been talking about the inevitability of higher interest rates for so long that, for many, calling this a trend seems like just another false alarm.

“There are those who believe concerns over increasing interest rates are overblown, that the economy is not strong enough to sustain increases, and that long-term rates are bound to fall again,” said Tim McWilliams, a senior investment officer for Catalyst Corporate FCU and a registered representative for CU Investment Solutions, LLC. “Whether interest rates rise now, in six months or in a year, if a credit union has bought long-term fixed-rate bonds, it is vulnerable to a potential continued rise in interest rates.”

Richard Fisher, president of the Dallas Federal Reserve, has coined a term for the current monetary environment. He has stated that the market is on “monetary cocaine,” alluding to the Fed’s $1 trillion-plus stimulus to the economy – through monthly large-scale asset purchases – over the course of its current quantitative easing program. When asked if he was concerned about the impact of rising bond yields on the economy, Fisher responded that policymakers could not let the markets dictate monetary policy.

“The Federal Reserve has been buying $85 billion a month in longer duration treasuries and mortgage-backed securities. These purchases have kept long-term interest rates at historically low levels, helping to revitalize the housing market and other sectors that rely on housing,” McWilliams said. “The Fed now is on record stating that they are ‘broadly comfortable’ with beginning to taper these purchases.” Many economists believe the Fed will decide to reduce the pace of the bond purchases as early as this month.

“The mere hint of the Fed removing that stimulus has caused the rate on 10-year treasuries to rise from 1.62 percent on May 2 to the current yield of 2.91 percent,” McWilliams said. “Whether the Fed begins to taper in September is anyone’s guess. The Fed has made it clear they want to end quantitative easing; it’s just a matter of how much they will taper and how quickly.”

Borrowing Fisher’s analogy, McWilliams said credit unions are prudent to consider whether the market has become “addicted” to low long-term interest rates. “If so, how bad will the withdrawal symptoms get? And without the Fed buying bonds, where will a free market reset long-term interest rates?” he asked.

McWilliams, with more than 25 years of industry experience, said that analyzing rising rate scenarios in a credit union’s ALM model is the first step in positioning its balance sheet to respond to these withdrawal symptoms. The second step is analyzing the credit union’s investment portfolio to determine if portfolio strategy or individual holdings are putting the credit union at risk.

“Does your credit union have a properly diversified portfolio? Does it have a mixture of both long-term and short-term bonds? Does utilizing a larger portion of adjustable-rate securities to hedge your fixed-rate holdings make sense?” McWilliams asked. “These are questions that credit union senior management needs to be asking now. It’s time to reevaluate your balance sheet and investment portfolio and determine the potential implications.”

For assistance with positioning balance sheets and investment portfolios for a rising interest rate environment, credit unions may contact Catalyst Corporate at contactis@catalystcorp.org or (800) 301-6196.