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There’s been concern over the potential long-term impact Hurricane Katrina and Rita might have on the U.S. economy. No doubt these two natural disasters were devastating to the area causing great residential displacement, loss of production and tremendous infrastructure damage. The hurricanes severely damaged drilling rigs and pipelines in the Gulf region that produces about 30% of the nation’s crude oil, 20% of our natural gas and 50% of the country’s refining capacity. Currently, 5% of the nation’s refining capacity remains closed and 10% of the nation’s refinery capacity is still off-line. Another 3% of U.S. capacity is operating under reduced runs. Following Katrina, crude oil prices reached $70 per barrel and the average gasoline price reached $3.07 per gallon. Since then, and following Rita, crude prices have fallen to $62 per barrel and average gasoline prices have declined to $2.85 per gallon. The Northeast region of the country will experience a more extreme shock this winter when consumers find out what it is going to cost to heat their homes given that heating oil prices have risen close to 80% since the first of the year. Combined energy costs may literally drive that part of the country into hibernation. Gas prices had already risen almost 43% since March but the consumer is just now starting to feel its pinch as disposable incomes have begun to fall. Only a moderate slowdown in consumer spending, accounting for two-thirds of the nation’s GDP will occur in 2006. Currently running at an annual pace of 5.7%, personal spending most likely will only fall to around 5.3% before it again picks up in the next few quarters. Unfortunately, even though wage and salary growth is higher than last year, it has not kept up with consumption over the past few quarters creating a “negative savings rate.” Credit unions should be concerned over the significant growth in the overall household debt burden of consumers. Although consumer debt is within reasonable levels based on income growth, when combined with mortgage debt, the burden has risen well over 100% since 2000. The recent change in bankruptcy laws saw a flood of applicants file before it went into effect on October 17th. What on the surface might look as potentially devastating to the economy might turn out to be less of an issue than what many have been speculating. Based on recently released economic data, the storms most likely will dilute economic growth by 0.4% in the third quarter and 0.2% in the fourth, according to the National Association for Business Economics. No one can ignore the fact a $200-billion federal reconstruction program will act as a generous stimulus program to the economy. This will help to expand payrolls at least by 1.6% next year matching this year’s expansion. This could lead to a modest acceleration in unit labor costs however (already rising 2.3% this year) putting upward pressure on inflation. Raw material costs, already on the rise over the past quarter, could also impact consumer prices if producers decide to pass on their higher costs. Most economists see the current trend, along with the hurricane impact, to be modest at best when it comes to the overall strength of the economy. As resources from the reconstruction program and as consumer supplies flood in from all parts of the country, prices will most likely not realize any adverse impact. Therefore, overall inflation, currently at 4.7%, will likely fall next year to between 3.0% and 3.5%. Core inflation, which excludes food and energy prices and currently at 2.0%, will likely rise modestly to a range of 2.2% to 2.4%. The Fed’s response to all of this is up for question. Notorious for overshooting their funds rate target to tighten credit and tame inflation, many have postulated the FOMC might not stop tightening until the fed funds rate reaches 4.50% next year, a level that some have said (including former Fed governor Larry Meyer) is an acceptable level as long as we have a healthy economy. For credit unions, what should be more important than the ultimate fed funds rate is the spread garnered from the shape of the treasury curve, that is, the relationship of rates. Currently, the spread between the benchmark two-year and the three- and five-year U.S. treasury note yields is three and eight basis points, respectively; providing no benefit for longer-term loans or investments. Similarly, the spread between the 2- and 10-year treasury, a benchmark for mortgage loans, is only 21 basis points. Loan and investment spreads, the difference between current market rates and these benchmarks, have also remained relatively tight over the past year. Most of the flatness in the treasury curve comes from the lack of upward movement of longer-term rates due partly from reduced foreign investment but mostly because the Fed continues to tip its hand on future monetary policy. Since credit unions have not had to raise their non-term share rates over the past 15 months, they’ve been able to protect net margins for 2005. With short-term rates on the rise over the near-term, upward pressure on cost of funds is currently the most critical factor to financial performance for the remainder of this year and all of next. Moreover, liquidity profiles have tightened as recent auto-makers’ employee discount incentive programs helped many credit unions reach their annual loan growth targets four months before the end of the year. Loan growth averaged between 14% and 15% between the second and third quarters while share growth was a modest 5%. The combination of tight liquidity, a flat yield curve environment and upward pressure on cost of funds complicates investment strategy. The marginal difference in loan and share growth rates will most likely diminish over the next six months. There is a misconception that a flat yield curve is always a precursor to falling short-term rates when in fact it is a technical indication of an economy transitioning from the end of a major cycle. There is no indication the economy is close to burning out or that the recent 275 basis point increase in short-term rates and the 21 basis point decline in longer-term rates signals a recessionary expectation. The flat rate environment is a confirmation that the last major interest rate cycle did indeed reach its nadir 19 months ago. In the near future, if the curve steepens from higher longer-term rates, portfolio average lives will extend as mortgage prepayments decline and callable investments begin performing more similar to bullet maturities. This will adversely impact already tight short-term liquidity. If short-term rates remain or decline from current levels for whatever reason, static mortgage prepayment will first keep portfolio duration extended but, depending upon the degree of decline, will eventually lead to higher prepayments and callable options being exercised, as was the case from 2000 to 2004. This will create adverse reinvestment risk whereby cash flow from loan and investment portfolios will be re-employed at lower than existing portfolio yields. Balance sheet cash flows must be structured to ensure a minimum level of monthly operating liquidity, adequate allocation of fixed term investment will protect against the possibility of declining short-term rates and amortizing structures are in place to prudently position for potentially higher interest rates.

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