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What To Watch For As QE3 Winds Down

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PLANO, Texas (7/5/13)--With the Federal Reserve's quantitative easing program perhaps winding down as early as mid-2014, credit unions can expect pressure to raise dividend and certificate rates to accompany increasing interest  rates, which will reduce earnings growth, said a Catalyst Corporate FCU analyst.
The impact of a slower infusion of stimulus on the economy means that "as the Fed slows down its purchases and even begins selling bonds it holds, bond prices will have to come down to meet the level of demand," said  Mark DeBree, Catalyst Strategic Solutions' director of asset liability analysis. "And when prices go down, yields go up, and interest rates will follow."
A slowing of the bond-buying stimulus could impact credit union earnings, loan demand, deposits and level of interest-rate risk. "If interest rates go up and the economy is strong enough to absorb the shock, consumers will continue to spend," he 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," DeBree said.

"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 with 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.
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 credit unions;
  • Narrowing gross margins with asset yields slow to move up;
  • Pressure to raise funding costs in response to rising interest rates; and
  • 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.

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.