50 basis point cut

By Joyce Moed, Reporter

SAN DIMAS, Calif.–One economist thinks that with its 50 basis point cut, the Federal Reserve is making a statement that they are concerned that the credit-market crunch will slow economic activity well into 2008.

“While a rate cut, or series of rate cuts, won’t suddenly turn bad bonds into good or heal the credit crisis, it could help lift other economic activity into 2008,” said Dwight Johnston, vice president of WesCorp. “I do not feel it is a one-time thing. I believe we will see further cuts, but the recent Fed actions tell me that the timing and magnitude of future rate cuts will not be as predictable as in the past.”

It’s a sentiment shared by Tom Moore, CFA, executive vice president of asset/liability management for Members United Corporate FCU in Warrenville, Ill., and president of Balance Sheet Solutions, LLC.

“The 50 basis point reduction was a clear statement by the FOMC that they have some concerns about the economic impact from the mortgage market, and more specifically, adjustable rate mortgages resetting in coming months, and the residual impact–higher delinquencies, increased debt service, reduced consumer purchases, etc.–that is a direct result from the mortgage industry events,” Moore said.

Brian Turner, manager of advisory services at Southwest Corporate in Dallas, said the Fed lowered its benchmark interest rate in hopes of “providing economic stimulus to the world’s largest economy.”

“The change ends a 15-month stand at 5.25% after a two-year run increases which lifted the overnight rate from 1%,” Turner said. “The FOMC also lowered the discount rate another 50 basis points to 5.25%, a 100 basis point decline since Aug. 16th, to provide psychological relief to the market and return investor confidence recently bitten by heightened credit concerns.”

Turner noted that policy-makers shifted their focus to growth from inflation in August as rising defaults on subprime mortgages rippled through global credit markets.

“Over the past 12 months, wholesale prices rose 2.2%, matching the year-over-year increase in costs excluding food and energy,” Turner said. “The August drop in wholesale prices was led by a 6.6% decline in energy costs.”

But with crude oil more recently surpassing $80 per barrel, Turner said that higher energy costs could be right around the corner. “Particularly as winter approaches and heating oil demand increases,” he said.

“The question persists whether a 50 basis point drop today will provide more economic stimulus or reignite long-term inflation,” Turner said.

Although surprised, Johnston was please to see the cut.

“I felt very strongly that the Fed should go 50 basis points on the cut, but I feared the stability in the stock market might convince them to go only 25,” he said. “I was surprised they went 50 but felt it was very much justified.”

Bob Post, vice president and chief investment officer for Corporate One Federal Credit Union in Columbus, Ohio, was also surprised by the cut.

“The 50 basis points cut was more aggressive than was generally expected,” he said. “Most economists were anticipated a 25 basis point cut. Whether the Fed cuts again will likely depend on future economic data over the next six weeks. If employment data for September reveals another weak report like August’s, and inflation data remains benign, then that may give the Fed room to lower rates another 25 basis points.”

Post said that according to the Fed, the cut was “intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in the financial markets and to promote moderate growth over time.”

Thanks to the rate cut, Johnston believes there will be a short period of relief in the credit markets, but added that he does not view this rate cut as a cure.

“I believe the next big story will be surprising economic weakness,” he said.

Moore said that more anticipation of further rate cuts will drive yields lower in the short end of the curve.

“And we have started seeing the yield curve steepen as longer term rates are affected by potential future inflation concerns,” he said.

One industry that may benefit from the rate cut is the credit-union industry, Johnston said, as CUs are in a good position to step in with effective loan processes and loan products.

“Quite simply, the credit mess has eliminated a lot of the competition,” he said. “But credit unions will have to consider that most mortgage loans, other than those conforming and sold to FNMA or FHLMC, will have to remain on their books.”

Moore agreed, saying that CUs continue to have a great opportunity to capitalize on the void that occurred as mortgage lenders exited the business or changed their underwriting standards.

“Credit unions are uniquely positioned to make high-quality loans to their members and consumers in general,” he said. “Credit unions have generally remained very competitive in the way they are pricing their mortgages, especially as it relates to conforming mortgages. An area of the mortgage market that is still a little unsettled is the jumbo loan secondary market where buyers of the credit unions’ loans are still adjusting to the diminished liquidity for these products. Credit unions should continue serving their members with great mortgage lending services and appropriately priced products to reflect their needs and risks. I believe credit unions do this better than any other type of lender in the market.”

There are continues to be some opportunities with mortgage-backed securities that are attractively priced relative to the risk of these investments, Moore said, and credit unions with excess liquidity should be evaluating whether this could be a good fit for them.
On the portfolio side, there is no right answer, Johnston said.

“For most of this year given our outlook for lower rates, we have advised credit unions to continue to focus on building laddered portfolios with bullet securities. We continue to maintain this stance.”

The rate cut has no bearing on WesCorp’s advice to credit unions, Johnston said.

“We continue to expect that rates will be lower into next year regardless of the Fed’s most recent action,” he said. “The Fed is a follower, not a leader on rates. We did warn credit unions as soon as the Fed cuts rates for the first time to expect longer-term rates to rise–not fall–for a few days or weeks. That is a fairly typical historical pattern. The bond market is a great anticipator of Fed moves, and when the Fed makes its first move, speculative traders in bonds usually take profits. That’s what we have seen, and there could be more of that coming.”

Post advises credit unions to pay close attention to the economic data in the near term as most economists expect signs of weakness, he said.

“This is a new Fed regime so it’s hard to predict how they will react with their policy moves. In past regimes, one move and done by the Fed was not usually the case. I’m not sure what credit unions will do with their loan rates. For deposit rates, since the yield curve actually steepened a little, rates may not be affected beyond one year. One money market and short-term rates, credit unions will most likely reduce them.”

Therefore, Post said that Corporate One FCU advises credit unions to have a laddered approach when it comes to managing their investment portfolio, which instill discipline, he said.
“For example, you will always have funds to re-invest monthly for a one-year term at current market interest rates, if you employ a one-year ladder, once a year passes by. This way it takes the guesswork out of which term to buy, which essentially, is a bet on interest rates,” he said.
For credit unions.

www.westcorp.org
www.membersunited.org
www.corpone.org
www.swcorp.org