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Is The Yield Curve Flattening?

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Going back to the end of 2015, the Federal Reserve has lifted the Fed Funds rate up from its zero lower bound to target a range of 1.25% to 1.50%, with additional tightening anticipated in 2018.

Often, when places model risk, it is assumed that when short-term rates move, long-term rates will move parallel.  Thus, when short-term rates increase, it is often expected that long-term rates will also increase—but this is often not the case.  From 2004 to 2006, the Fed raised the Fed Funds rate from its target of 1.00% up to 5.25%.  Short-term rates responded, but long-term rates did not move very much.  This led to then-Federal Reserve Chairman Alan Greenspan’s “conundrum” comment and an inverted yield curve:

A graph showing the compression of yield curve, 2004-2006

Since longer-term rates influence yield on assets, and shorter-term rates influence cost of funds, the difference between short- and long-term rates is important for credit union earnings.  When the difference is larger it can help credit union margins, and when short- and long-term rates are closer together, it can squeeze margins.  A sophisticated model should automatically change the shape of, or “twist,” the yield curve with every simulation and what-if scenario that is modeled.

The importance of twisting the yield curve on every simulation and what-if scenario cannot be overlooked.  During the tightening from 2004 to 2006, for example, cost of funds for credit unions $1 billion to $10 billion in assets increased 1.27%, while the yield on earning assets increased just 0.88%, according to NCUA data.  This move took about a 40 bp bite out of these credit unions’ net interest margins.

As we look at recent history, we see that, once again, as the Fed is tightening its rates, the yield curve is compressing.  Will it flatten out or invert as it did the last time the Fed tightened?  No one knows, but it is compressing:

A graph showing the compression of yield curve, 2015-2017

Assuming a parallel increase will generate a higher yield on assets and will result in a higher simulated margin than may be experienced with yield curve compression.  Often, twists of the yield curve are incorporated into modeling once per year as part of stress testing.  Compression of the yield curve as the Fed tightens is not a stress test.  History has shown this to be a common expectation.  We run thousands of simulations and what-if scenarios every year, each one of them testing a wide range of rate environments and yield curve shapes.  We encourage every institution to incorporate the real risk of yield curves changing in every simulation.

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Selling Investments for Liquidity

A few weeks ago, we discussed increasing loan-to-share ratios resulting from loan growth outpacing share growth.  The blog went on to discuss the potential liquidity pressures some could experience, today or in the future, if this trend continues.

To keep the lending machine going, many decision-makers maintain that to fund future loan growth they will sell investments in the future.  While this may be an option worth considering, market rates in the future are uncertain and it can take a considerable amount of time to offset losses you may take on the sale of investments.  Let’s walk through an example:

Assume a credit union is experiencing continued loan growth and it also holds a $100M agency bullet, with three years remaining until maturity, earning 0.75%.  Their liquidity analysis is projecting they may need to sell this investment in 12 months to help fund loan opportunities.

Rates could go in any direction but what if rates increase 1% in the next 12 months?  The credit union sells the $100M investment, now with two years remaining until maturity, at a $1.6M loss.  If rates increase 3% in the next 12 months, the loss is $5.4M.

Sell Asset in 12 Months

Beyond asking if the credit union is willing to take the loss, the next question should be, How long it will take new lending opportunities to offset the loss? Assuming loans will yield more as rates go up, it could take up to six months to recoup the loss on the sale in a +100 basis point (bp) increase in rates and 17 months in a +300 bp increase in rates.

Months to Breakeven

The objective here is not to advocate a particular strategy, rather to encourage thorough analysis and provide a different perspective for credit union boards and managements to understand the trade-offs of difficult decisions.

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Liquidity Risk: Loan-to-Share Ratios Are Moving Up

Throughout the sustained, low interest rate environment, many credit unions have become flush with non-maturity deposit funds, while also experiencing lackluster loan growth.  In other words, liquidity risk hasn’t necessarily been at top of mind.

However, as the economic landscape shifts and murmurings of an increase in government interest rates grow, the issue of liquidity may become an increasing concern once again.  According to June 2014 NCUA Aggregate data, loan growth (on average) continues to outpace share growth.  What if this trend continues and/or accelerates?

NCUA Aggregate Data Table

One thing to consider is analyzing how your members’ average balances have evolved since the last economic rate cycle back in the summer of 2007 when short-term rates were at 5%.  Key areas to address include:

  • What would my liquidity position look like if members reverted back to historical average balances?
  • What options do I have available, and what are the financial implications of those options, if the above scenario caused a stressed liquidity position?
  • As discussed in earlier blogs, the mix and cost of your deposits will also change as rates rise.  See our post on Isolating Interest Rate Risk with a Static Balance Sheet for more detail on this

While it may not feel like a problem today, highly successful credit unions are continuously looking forward and staying ahead of the curve.  Take the time to understand your liquidity position today and the threats and opportunities of tomorrow so that when the future is realized, you’ll be better prepared.