After fourteen increases in the Fed Funds target starting in June 2004 with another expected on June 29, 2006, the Treasury yield curve is slightly inverted. The common definition of an inverted yield curve is when the two-year Treasury’s yield exceeds the ten-year Treasury’s yield. Notice that the ten-year Treasury’s yield has moved only 71 basis points since May 2004. However, the two-year Treasury has climbed significantly over the last two years-plus, increasing by 292 basis points over that period. Depending on economic growth, perceived inflation, and FOMC activity, the yield curve may invert even more this year, as the FOMC is expected to continue the fight against inflation. 

The Cause
The common cause of an inverted curve is the dynamics between the FOMC’s inflation-fighting stance and what the market perceives inflation to be in the future. The FOMC raises the Fed Funds target to rein in perceived inflation pressures. The markets “bid up” the price on longer-term Treasuries because they feel that the FOMC will have inflation well under control into the future. These higher prices reduce the yields on longer-term Treasury Bonds because yields move inversely to prices. 

The FOMC has been energetic in its effort to fight inflation in this current tightening cycle, and has not missed an opportunity to raise the Fed Funds target. The end result of the FOMC’s tightening will be a dampening of economic growth. Either the economy will go into a recession (the usual result of raising rates), or GDP growth will slow from its current levels. Either result will reduce demand and, in theory, help contain inflation. Economists are predicting that the FOMC has only a few moves left before it will stop tightening in this current cycle. Some economists predict that by year-end the FOMC will increase the Fed Funds target to 5.75, as this tightening cycle is finally expected to slow the economy at that Fed Funds target level.

The Slope
When the yield curve is sloping upward, the temptation is to borrow short and lend long. The NCUA is less than pleased if too much short-term borrowing and long-term fixed-rate lending, go on in credit unions’ balance sheets. To discourage that behavior, the NCUA tracks credit unions’ net economic value (NEV), and reserves the right to force corrective action if too much interest rate sensitivity is present. The greater the disparity between the sensitivity of shares versus assets to interest rate changes, the greater the change in NEV. The inverted curve has taken most of the benefit out of a short versus a long mismatch between liabilities and assets, so there is little or no money to be made there.

What It All Means, What You Can Do
What this means to credit unions is that to stay competitive, member short-term shares will get more expensive, while longer-term fixed-rate loans will stay relatively unchanged for the foreseeable future. Flat yield curves put significant pressure on profit margins, but inverted yield curves have even greater deleterious effects, especially if they continue for any length of time. There are no panaceas for this unpleasant yield curve environment that give an immediate return to wider net interest margins. However, there are some steps your credit union can take. 

Naturally, you should always focus on containing or reducing non-interest expenses at your credit union. Just as important, though, is to look at the nature of the loans on your balance sheet, and any securities you own. If you are making a significant amount of fixed-rate loans, you may want to think about selling your new fixed-rate production. 

During periods of inverted yield curves, floating-rate assets provide excellent returns and should be considered. A great loan product is the floating-rate home equity loan. Unfortunately, the NCUA does not allow credit unions to buy asset-backed securities (ABSs) based on this loan product.

Securities credit unions can buy are collateralized mortgage obligations (CMOs) that have floating-rate tranches. Floating-rate tranches are indexed to LIBOR, which closely tracks the Fed Funds target with a positive spread. As the FOMC raises the target rate, these tranches reset to higher rates. 

A short time ago, the perceived spread between short-term shares (costing less than one percent), and thirty-year fixed-rate mortgages (yielding over five percent), seemed huge. That spread has declined since then, and if short-term rates climb any higher, it will get even smaller. 

In the current economic environment, short-term rates are high relative to long-term rates, which makes floating-rate securities much more attractive. The perceived spread may appear narrow, but will stay with you as short-term rates rise. It’s a challenging time for all of us, but you can always turn to Members United and Balance Sheet Solutions, LLC for assistance.