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Rising-rate environment stays on track: Investment strategies to consider

By: Jeff Duesler, Senior Investment Services Representative

2018 Second Quarter Economic Update

We’re shaking things up for the next quarterly economic update and letting you submit questions and define the discussion. What economic marketplace questions will you have half-way through 2018 for Bob Post, Corporate One’s Chief Investment Officer, and his team? Email your questions to mmurray@corporateone.coop by June 13, 2018. We’ll field the top three or four questions for the discussion during the webinar and follow-up on any we can’t get to afterwards. And, don’t worry, Bob will still do a quick analysis of the latest news coming out of the FOMC, like always.

June 19, 2018
2:00 p.m. ET

The Federal Reserve Open Market Committee (FOMC) announced the first expected rate hike of the year on March 21, and no one in the markets was surprised. Interest rates continue to rise predictably and transparently; the FOMC has been gradually raising rates since the end of 2015. Unless something unexpected pops up, everything is on track for two more rate hikes this year. In this ongoing, rising-rate environment, I’d like to suggest a few familiar strategies to consider for your credit union’s investment portfolio. These strategies aim to protect the portfolio from rising rates and help it benefit from investment opportunities.

First, here’s a brief summary of what happened on March 21 and what we can expect going forward.

Plotting the FOMC’s rate predictions

After the FOMC meets, they release a statistical analysis called a “dot plot.” FOMC participants are invited to make (plot) their predictions for an appropriate Fed funds rate at the end of the year, and each prediction is represented by a dot. The release of this particular dot plot was highly anticipated because of growing speculation prior to March 21 that the FOMC would actually raise rates four times this year instead of the previously predicted three. Below is an image from Bloomberg of the FOMC’s dot plot released after the meeting on March 21:

The Y axis displays the years (from left to right: 2018, 2019, 2020, and Longer Term), and the X axis displays the Implied Fed Funds Target Rate (rates ascend from bottom to top in the order 1.5, 2.00, 2.5, 3.0, 3.5, etc.) Based on this dot plot, the majority of FOMC participants expect the target overnight rate to be between 2.00% and 2.25% at the end of 2018, which aligns with the number of rate hikes originally predicted (three).

The reaffirmation represented by the dot plot calmed down markets that had been extremely volatile in the days leading up to the meeting and caused equities to rally due to the prospect of economic growth (per the FOMC’s statement and no surprises in terms of future rate hikes).

Looking at other predictions

The following chart, also from Bloomberg, represents quarterly interest rate predictions from contributing broker-dealers.

While anything can change between now and the end of the year, this data confirms the likelihood that the FOMC will raise rates at least two times more this year.

What this means for your credit union

Since the FOMC has been in the tightening cycle to normalize interest rates, Corporate One has been offering suggestions on strategies for your investment portfolio not only to offer protection for higher rates but also to help your portfolio benefit from those higher rates.

Because market timing typically doesn’t work well for fixed-income investing, here are a few familiar strategies to keep in mind.

Stick with your current strategy. Manage the investment portfolio to compliment the overall balance sheet. The second part of this suggestion is one that doesn’t change no matter the interest rate environment. Laddered strategies in example will insulate the portfolio from fluctuations in interest rates. Deviating from this for example going outside the original laddered parameters set to “chase rates” isn’t the most prudent decision.

Consider U.S. Treasuries. U.S. Treasuries offer an alternative to CDs and bullet agencies especially when it comes to filling in a ladder for several reasons including a) US Treasuries are highly liquid and trade consistently when you invest in a treasury you are investing at the current market rate at that point in time. b) US treasuries are 100% government guaranteed and 0% risk rated. c) Treasuries are good to fill in ladders because of their regular issuance.

Consider callable securities in both the primary and secondary markets. Investors get paid to take on call risk. When rates go up the probability of a bond call goes down. In this scenario, the Investor benefits on the extra yield received to take the risk of it being called.

Consider securities that amortize. Mortgage-backed securities pay interest and principal monthly. This allows the investor to receive current rates on the reinvestment funds.

Select securities that benefit from rate changes. These are floating rate securities that come in a couple of different forms. Floating-rate securities have coupons that adjust to higher or lower interest rates. SBA securities are securitized pools of small business loans that pay a stated rate in basis points above or below the Prime rate. CMO floaters are structured, mortgage-backed securities that index to a short-term rate, usually the 1-month LIBOR rate.

Floating-rate, corporate, and government agency debt can use several different short term indexes. One common index used is the 3-month LIBOR. Since the beginning of the year, the 3-month LIBOR rate is up over 60 basis points. It has moved up around 30 basis points since the end of February. Investors who have securities that are tied to the 3-month LIBOR have benefited from this higher coupon.

Strategizing for the future

There isn’t a one-size-fits-all investment strategy for credit unions. But having a strategy is half the battle. I hope you’ll reach out to our investment representatives here at Corporate One; we are happy to consult with you on a customized investment strategy that best fits your credit union’s needs.