Pub. 1 2010 Issue 1

spring 2010 17 Q Interest Rates — continued on page 21 will be very cautious in tightening mon- etary policy and raising interest rates. With an economy forecasted to expand at a rate between 2% and 2.5% in 2010 we are not likely to see a significant decline in the unemployment rate. The level of economic growth in 2010 will depend on a number of factors, but most impor- tantly the consumer, the housing market and government spending. Personal consumption accounts for 67 to 70% of GDP; therefore as the consumer goes the economy goes. Retail sales were bol- stered in the 2nd half of 2009 by “cash for clunkers”, but without this government incentive 4th quarter retail sales were disappointing. Consumer confidence has rebounded, but not to the level to suggest robust activity in 2010. Probably most im- portantly, consumers are saving more of their income and reducing personal debt. These are wonderful long-term attributes, but do little to promote short-term con- sumption and economic activity. The housing crisis was the origin of our current problems. The crisis began in 2007 as housing values began to decline after years of appreciation. Economic conditions differ across the country; therefore we need to be careful relying on national forecasts. This is particu- larly the case with housing - national statistics are significantly biased by conditions in California and Florida. That said a stronger housing rebound is critically important for both the construc- tion and durable goods industries. We will not experience normalized growth in these sectors until foreclosure rates substantially decline and that is not likely to happen in the foreseeable future. The Federal government was an active participant in the economy in 2009 through both an $800 billion stimulus package and a $1.7 trillion deficit. Con- gress is indicating continued stimulation in 2010 with more of a direct focus on jobs. The level of intensity will increase at an exponential rate based on the un- employment rate and the time line to the November elections. Double digit unem- ployment is anathema to incumbents; therefore House Democrats are likely to force as much stimulus as necessary to reduce the unemployment rate. Bankers also care about interest rates. The yield curve will eventually revert to its mean and this will likely start in 2010 if it hasn’t started already. The volatility of the 10 year Treasury note in the 4th quarter of 2009 was unprecedented – 3.17% low to 3.89% high and finishing the year at the upper end of the range. Bank manag- ers too often get fixated on the short-end of the curve, probably because we focus on the Federal Reserve Open Market Committee (FOMC) meetings every six weeks. It may be more important to focus on the longer end of the curve in the first two quarters of 2010 because this is where inflationary expectations influence inter- est rates. The Fed has pumped massive amounts of liquidity into the economy in the last two years – the Fed balance sheet has more than doubled. Mr. Bernanke has suggested on a number of occasions that eventually the process needs to be reversed. Not mopping up excess liquid- ity will eventually accelerate inflationary pressure; whereas mopping up liquidity means higher interest rates and probably sooner rather than later. Expect the 10 year Treasury note to remain at the higher end of its recent range (3.80%) through the 1st quarter of 2010. By the 2nd quarter the Fed will likely end its intervention in the bond and mortgage backed security markets which should drive the 10 year above 4% and steepen the yield curve. As we prog- ress through 2010 the yield curve will continue to steepen to the point where the Fed Open Market Committee will need to raise short-term rates to counter inflation expectations. Summary of assumptions for your Asset/Liability Committee’s (ALCO) decision making in 2010: Entering the year with excess liquidity. Economic expansion at 2.5% gradu- ally improving loan demand as the year progresses. The Fed funds rate will likely begin to increase in the 3rd quarter – 1.25% by year end. The 10 year Treasury note will start the year at 3.80% and gradually move to 4.10% by the 3rd quarter. 30 year mortgage interest rates will gradually rise to 5.75% by 3rd quarter As households continue to save deposit inflows will be high than normal, but not as robust as 2009. Given this scenario what strategies should your ALCO consider pursu- ing? Based on the interest rate forecast the general approach to balance sheet management would be to shorten asset duration and lengthen liability duration. Secondly, growth will be difficult in 2010 as it was in 2009. The economic forecast suggests loan demand will not be robust unless you are willing to assume more credit risk which is not recommended until the economy gains some traction. Without sufficient loan demand, growth will need to come from the investment portfolio. Given the interest rate forecast, short-term investments are the order of the day, but the yields are not very at- tractive. Long-term investment (greater than 2 & 1/2 years) decisions are likely to come back and haunt us in 2011. Invest- ment decision making will become more difficult in the second half of 2010 as we get closer to a Fed decision to raise rates. Asset management will remain a chal- lenge in 2010 as long as we don’t have loan growth. The slower your bank grows the less chance you will make a mistake – ironically banks make mistakes at the turning point in cycles. Liability management will also be a challenge. The banks in the cat bird seat are the ones with large amounts of Federal Home Loan Bank advances maturing in 2010 as they will have flex- ibility in repositioning their liabilities and/or accepting a lower cost of funds. Deposit inflows should continue to