Light at the End of the Tunnel?

Conflicting data has left bond investors thoroughly uncertain about the FOMC’s next interest rate move.


Last week, for the sixteenth time in as many meetings, the Federal Open Market Committee (FOMC) raised the federal funds rate a quarter of a point.  The benchmark rate now stands at 5.00%, the highest level since June 2001. The FOMC will meet next on June 28 and again on August 8, but economic data is not providing clear evidence supporting a particular FOMC action.

End of Increases?
While previously there was consensus in the market about the direction of the interest rates, sentiment is now divided.  One reason for this divergence is the most recent labor report, which noted that fewer jobs were created in April, but that wages rose.  Investors took the weaker-than-expected number of jobs as a sign that the economy is cooling. On the other hand, rising paychecks show strength in the labor market and might offset some of the pain brought on by higher fuel prices and a cooling housing market.

Bloomberg surveyed 82 analysts to see where they thought interest rates would be in the third quarter of 2006. The majority of those surveyed predicted that the Fed would hold at 5.00%. The chart below shows the results of the survey:

However, this survey pre-dated the most recent inflation report, which roiled the bond market with its revelations of rising prices, which may reduce the likelihood that the FOMC will hold the overnight rate at 5.00% when it meets in June.

What Does This Mean for Credit Unions?
Movement in the federal funds rate and share growth at credit unions have a very strong inverse relationship as seen in the graph below.  Because credit unions’ dividend rates typically lag the market, credit union share growth tends to accelerate in periods when their rates are higher than alternatives.  Conversely, credit unions typically see share growth decelerate in periods of rising interest rates, when other vehicles often offer more attractive rates.  The tightening trend of the past two years has coincided with the slowest rate of share growth in the past decade.


The level of interest rates is not the only factor that is correlated with share growth.  The performance of other investment alternatives like the stock and housing markets also has an impact on shares.  The stock market’s recent bobble in response to higher uncertainty in economic performance could stimulate increased demand for less volatile assets such as share certificates.