Preparing for Fall (And a Falling Rate Environment)

For many people, autumn is an enjoyable time of transition. I look forward to a lot of familiar facets of fall, like the cooler weather, the start of football season, major league baseball post-season and the kids returning to school, to name a few.  But as the new season approaches, there’s another fall we need to be ready for…and that’s the ongoing possibility of falling interest rates.

First, let me be clear that this article is not an attempt at prognosticating the next fed rate decision in September. The last federal funds rate cut was in December 2024, and although there have been rumblings in the bond market, and the President’s stance is clear, this isn’t an indication that a cut is imminent.

It’s important to understand how FOMC voting members gather economic insights. They use information from numerous indicators and don’t rely solely on inflation and employment metrics to devise monetary policy. Additionally, they consider several indicators, from housing starts to consumer spending, to gauge just how well the economy is performing. These items can point in various directions at different times, so it’s best to avoid thinking in absolutes about any type of rate change.

Ways to Prepare Your Balance Sheet to Absorb Risk

However, if your credit union is preparing its balance sheet to weather any future rate changes with minimal risk, consider the wise words of Benjamin Franklin,

“By failing to prepare, you are preparing to fail.” 

With this thought in mind, let’s examine the ways your credit union can prepare your balance sheet to absorb risk in various rate environments, especially falling ones.

Currently, most credit unions are positioned to have lower earnings in a falling rate environment. Why is that? It’s partly inevitable because, like any business, credit unions need to have available cash and short-term liquid investments to meet daily operating requirements. Interest-bearing cash levels will be the most susceptible to a changing rate environment.

However, is your credit union carrying too much cash? While the answer might vary depending on your credit union and your risk tolerance level, if you feel like this is the case, there are a few strategies available to alleviate some downward earnings pressure:

• Focus on ways to extend asset duration. This can be accomplished through the purchase of several different products, which include:
  • Issuing longer-term fixed rate and longer to initial coupon reset adjustable-rate loans
  • Residential mortgage and commercial participations
  • Fixed-rate MBS and SBA bonds (and adjustable-rate SBA bonds with floors)
  • Bullet agency bonds and US Treasuries
  • Investment Certificates

Additional Considerations for Reducing Risk in an Interest Fall

Another risk contributor is the rapid repricing that can occur in down-rate scenarios. Typically, this takes place in real estate, as members look at prepaying and refinancing mortgages, or callable investments when the call feature is activated. If rates get pushed down further over the next year or two, as some have suggested, a significant number of members will refinance their mortgages. Similarly, agency callable investments could be impacted depending on the decrease, and thereby earn less, if they are replaced with similar products having less yield.

While the products listed above can help curb risk during down-rate scenarios with excess cash, prepays can also impact some of those products, as with residential mortgage products. For example, imagine your credit union has purchased a 30-year fixed participation portfolio that yields six percent. In a down scenario, with accelerated cashflow from prepayments would be placed into Federal Funds overnight cash, bringing the overall yield down by roughly one percent. Despite the rate cycle, this is a strong yield. It’s also an important reminder to never sacrifice quality for yield in your loan portfolio, for both internally generated and participation loans.

Consideration in Case of an Increase

In rising rate environments, the above participation purchase example will have less prepayments and the current yield on those mortgages would remain strong. In this situation, your credit union has downside protection without significant upside risk.  

Keep in mind that in the case of a rising rate environment, there will be other risks to consider. That is the useful aspect of ALM, where we want to monitor the risks even when the rate scenario is unlikely. We don’t have to look historically too far to see unexpected market changes and the potential risk it brings. Although it appears improbable it is possible rates will rise to keep tabs on these environments as well.

Market Condition Considerations

Finally, there are other market conditions to consider during falling rate environments:

• Historically, liquidity increases due to flight to safety, however given high current rates, members may keep funds in higher yielding products keeping COF higher. Credit unions can handle this risk by managing offering rates appropriately. 
• Usually, in down rate cycles, economic conditions are tightening, many times this leads to slower lending. Credit unions need to be willing to utilize other assets like listed above to help yield and maintain capital.
• Loan and investment opportunities are at lower yields. This is why we are encouraging credit unions to take strategic action now. In lower yield environments, credit unions can adjust offering rates, but after that, there are less options available before operating costs are affected.

In summary, there is no guarantee when it comes to interest rates. They generally tend to be slower to move, but that isn’t always the case, as demonstrated in the past few years. Evaluate your opportunities to add earnings protection without generating a significant impact in the case of a rate increase. Ultimately, be like Ben Franklin. Be prepared and take advantage of the current opportunities while they exist.

Jamie Thacker is a senior asset/liability management (ALM) consultant for Vizo Financial. He joined Vizo Financial in 2015, and he is responsible for providing ALM reporting, modeling and consulting services to credit unions.