5 things you need to know: managing interest rate risk after the Fed remains hawkish in 2023

If you have been wondering when to hedge your organization’s interest rate risk, now is a great time to review these five key considerations for effectively managing interest rate risk in the current market environment.

(Updated as of 8/9/2023)

1. There may be a disconnect between the market and the Fed

The Federal Reserve has been resolute in its commitment to taming inflation by “any means necessary.” With eleven interest rate hikes totaling 525 basis points since March 2022, the Fed has been on its fastest pace of rate increases in four decades. As the U.S. economy continues to show signs of resiliency, the Fed continues to be focused on the data and has not ruled out future rate hikes. Meanwhile, the market has priced in cuts beginning in March 2024.

2. A window of opportunity is open to hedge floating-rate risk

This decoupling between market participants’ beliefs and Fed speak has diminished in recent weeks as the market has pushed out its expectations for rate cuts. Nevertheless, a gap is still prevalent, presenting a window of opportunity for corporates who have been reluctant to hedge.

Because the inverted yield curve has already priced in the market’s expectations for future rate decreases, corporates looking to reduce interest rate risk and volatility by fixing a portion of their floating rate debt can lock in a swap rate that provides immediate interest expense benefit relative to the current floating rate (over 110 basis points for 3 years and nearly 150 basis points for 5 years as of August 9). Furthermore, the Fed would have to cut rates more aggressively than what the market is expecting for it to not yield a net benefit for your organization.

3. This window of opportunity for hedging floating rate risk may not last long

With growing talks of a soft landing for the U.S. economy, investors have begun to accept that interest rates may remain higher for longer than previously anticipated.

As illustrated in the graph below, rates fell to their lowest levels this year following the collapse of Silicon Valley Bank in March 2023, as many believed a recession was imminent. Since then, as data have suggested that the Fed’s goals of a soft landing of the U.S. economy may in fact come to fruition, markets have repriced their expectations of the Fed’s next moves significantly. This highlights a shifting sentiment that the Federal Reserve will need to keep rates higher for longer, a stark contrast to market expectations from earlier in the year.

For companies that have been reluctant to lock in at such levels because they were anticipating a recession, there are still opportunities to take some floating-rate risk off the table. For the time being, three- and five-year swap rates remain inverted relative to floating rates. While these rates have recalibrated meaningfully since March, they still reflect a chance to lock in anticipated Fed rate cuts that may or may not materialize in a soft-landing environment.

Companies looking to lock in rates can now gain an immediate benefit in the short term from a lower fixed rate than the current floating rate but, as curves continue to shift, that window may close quickly.

4. Diverging central bank strategies are lowering the potential interest pickup for some cross-currency markets

Due to the cross-currency basis that exists among certain currency pairs, corporates may take advantage of an interest rate pickup across certain geographies to reduce interest expense. This pickup has already eroded in some currencies relative to the dollar due to the expectation that other central banks will hike rates more aggressively than the Fed. While the interest rate pickup that can be achieved through cross-currency hedging is still attractive for many organizations, the window of opportunity associated with this strategy for certain currencies may compress further over time:

• EUR: The European Central Bank is expected to continue to raise rates at a faster pace than the Federal Reserve, leading to erosion in the available pickup for EUR cross-currency swaps.
• CHF: The Swiss National Bank is expected to continue to hike rates, although at a slower pace than the ECB, also leading to a lower pickup.
• JPY: The Bank of Japan is expected to hold short-term rates in negative territory, leading to an attractive pickup and a ripe opportunity to capitalize on attractive interest rate differentials. It is worth noting that transaction charges for JPY cross-currency swaps may be higher than other currencies due to higher levels of volatility in the USD-JPY spot rate.
• CNH: The pickup for CNH cross-currency swaps is expected to continue to increase as the Federal Reserve raises rates. However, market opaqueness and hedge accounting challenges present additional nuances that companies will need to navigate if they elect to pursue such a strategy.

5. Corporates can hedge future fixed-rate issuances at current market levels

Companies planning to issue fixed-rate debt in the future are exposed to fluctuations in interest rates between now and the debt issuance date. Similar to hedging floating rate debt, organizations can lock in a hedge for a future date at a fixed rate that is lower than today’s spot starting rate given the current inversion of the forward curve.

Due to the nuanced nature of pre-issuance hedging transactions, layering in hedges over time can help to reduce the volatility associated with pricing a bond issuance at a singular point in time. If you are issuing in the future and concerned about what the level of rates could be on that future date, executing a series of forward-starting interest rate swaps that are layered in over time allows the company to capture an average market level and avoid significant volatility around the specific issuance date.

The bottom line

In light of today’s rate environment, it is important to revisit your company’s current interest rate risk management strategy and determine if now is the right time to hedge. As the market continues to evolve, Chatham’s hedging advisory team has the insights and expertise needed to design and execute a best-in-class hedging strategy based on your economic and accounting objectives.