Fed hawks have landed

Federal Open Market Committee (FOMC) minutes move markets

Last Wednesday, the FOMC’s minutes were released from the March 2022 meeting. Below are the key takeaways:

• Although no definitive decision was made, the committee generally agreed to begin shrinking the Fed’s balance sheet by up to $95 billion a month at the next FOMC meeting in May.
• The committee proposed reducing treasury securities by up to $60 billion a month and mortgage-backed securities (MBS) by up to $35 billion a month.
• Initially, the reduction would be primarily completed by adjusting the amount of principal payments reinvested. However, the committee noted once asset reduction was well under way, it may be appropriate to begin actively selling MBS to meet the reduction target.
• Several members suggested they would be comfortable with no caps on balance sheet reduction but ultimately agreed to the figures detailed above.
• “Many” participants said they would have preferred a 50-basis point rate hike at the meeting rather than the agreed 25-basis point hike.
• “Many” participants also said they felt one or more 50-basis point rate hikes would be warranted at upcoming FOMC meetings if high levels of inflation persist.
• Some participants expressed concerns that inflation could become entrenched if the Fed did not act decisively to combat it.
• The committee lowered its one-year and two-year GDP forecasts and simultaneously increased its inflation forecast over the same periods.
• The committee voted to increase the federal funds rate to a target range of 0.25% to 0.50%.

Prior to Governor Brainard announcing to markets earlier last week that balance sheet reduction would begin soon and “at a rapid pace,” markets were not pricing in such a fast reduction. For perspective, this asset sheet reduction would be roughly double the pace that occurred in 2017-2019. During the pandemic, the Fed bought approximately $1.5 trillion in assets with tenors greater than 5 years. The Fed’s balance sheet, however, primarily consists of treasuries with tenors of less than 5 years, as shown in the graph below. As a result, the Fed will primarily shed its shorter-term assets as balance sheet reduction begins and will have a substantially larger impact on short-term rates as compared to long-term rates.

Likewise, as displayed above, treasury yields have also increased as the Fed takes on a more hawkish tone. The 2-year treasury yield has increased much faster than the 10-year treasury yield in the last few months as the market prices in additional FOMC rate hikes and an asset reduction that primarily impacts shorter tenor treasury rates. As of April 8, the 10-year treasury yield was 2.72% and the 2-year treasury yield was 2.47%. The spread between the two yields has narrowed substantially, and some large banks expressed concerns over a potential recession. However other estimates indicate that without the Fed’s asset program, the 10-year yield would be roughly 3.6%. The Fed itself has said that it would be more appropriate to compare yield tenors shorter than 2-years to the 10-year for a more accurate predictor of any potential recessionary environment ahead.

With the current rate environment in mind, corporations can benefit from reassessing their interest rate exposure. The market now predicts an average of 12 additional 25-basis-point hikes in the next 15 months. From a historical perspective, the market also often underestimates the number of rate hikes that occur during tightening cycles. Therefore, swapping some floating-rate debt to fixed-rate debt could be advantageous for corporations. This is especially true over longer tenors because current forward curves predict rates will decline and then flatten for tenors over 2.5 years. The expected reduction and flattening would lower the current fixed rate corporations could lock in today despite the unknown path of rate increases 16 months from now.

(Related insight: Register for the webinar, "Pre-Issuance Hedging Strategies for Corporates")

Commodities

Commodity volatility continues because of supply bottlenecks and the Russian-Ukraine war. Most notably this week, the price of crude has been increasingly less useful as a hedge against gasoline, diesel, and jet fuel. As of April 8, the difference between an equivalent number of gallons of gasoline, diesel, and jet fuel compared to Brent was $26.79, $41.41, and $41.20 respectively. All three statistics are at least twice as high as they were prior to the Russian invasion. These differences are due primarily to Russian sanctions. Since Russia is also a large exporter of refined petroleum products, sanctions are making it harder to source them. What this means for companies utilizing the refined products is that hedging is becoming increasingly difficult. Many companies hedge against crude oil to match their underlying exposures to gasoline, diesel, and jet fuel. Unfortunately, in the current environment, these hedges are proving ineffective as the price between the two commodities diverge. Companies should continue to reevaluate the effectiveness of their commodity hedges to ensure they are appropriately protecting them in the current market environment.

(Related insight: Read "7 ways to maximize FX and commodity hedging impact while minimizing costs")