FOMC sets the stage for rate tightening cycle
Corporates | Kennett Square, PA
The FOMC took a resolute stance on acknowledging the mix of high inflation and a strong labor market at its January meeting, paving the way for multiple rate hikes in 2022. Rates markets responded with higher rates across the curve, forcing many borrowers to grapple with new hedging complexities.
January FOMC meeting details
While no rate hike was expected at the FOMC meeting last week, the Fed did exceed market expectations in terms of tone and posture regarding impending rate hikes. Fed Chair Jerome Powell addressed the dangers of inflation staying at current levels and acknowledged the strength of the current labor market; by using firmer language than in prior meetings, Powell sent a strong message to the market in terms of expected rate hikes. When pressed, Powell did not rule out as many as seven discrete 0.25% rate hikes this year, though the market is currently pricing in between five and six hikes.
The Fed is in company with numerous central banks around the globe that are on the cusp of tightening rates: The Bank of Canada, Bank of England, and Reserve Bank of Australia are all poised to hike rates at subsequent meetings. While equity markets floundered in the face of tighter financial conditions and inflation, interest rate markets moved steadily upward.
Interest rate hedging implications
Building on levels that had already factored in numerous rate hikes, interest rate curves moved up further following the Wednesday Fed meeting. The 10-year Treasury yield jumped to over 1.86%, the highest level since January 2020. Meanwhile, the 2-year and 5-year notes rose to 1.20% and 1.68%, respectively. By way of comparison, the cost of hedging two years of interest rate risk has now doubled from under 0.60% at the beginning of December.
Companies looking to hedge interest rate risk are now vexed with a difficult question: is it too late to hedge interest rate risk because the tightening cycle has already been priced in? Aside from the reporting benefit of removing P&L volatility via hedging, Chatham still advises clients to pursue hedging in this environment for a number of reasons. First, rate hikes could prove to be more aggressive than expected if inflation persists; indeed, Jerome Powell attested that the current supply chain issues may not be worked out this year. Additionally, regardless of what the Fed actually does, the cost of locking in rates could be higher in the future if market expectation shifts upward. Finally, historical data shows that the forward curve often underestimates the magnitude of rate hikes during tightening cycles, suggesting companies should indeed hedge if history were to repeat itself.
FX and commodity developments
Reversing a brief weakening trend exhibited in the early weeks of 2022, the dollar resumed a strengthening trend following the FOMC meeting. Against the EUR in particular, at a rate of 1.1127, the EUR reached its weakest point against the dollar since June 2020. Of note, the European Central Bank stated it will take a measured approach towards rate hikes, with its first not being priced in until November of this year. All else equal, that gap in central bank policy is driving the current state of weakness in the euro.
Commodity markets were also not immune to post-Fed volatility. Crude oil eclipsed $91 per barrel, the first time since 2014. Some market analysts are calling for prices of $100 or $110 per barrel in future periods, as the current inflationary environment, macro demand, and geopolitical instability are all putting upward pressure on prices. From a hedging perspective, Chatham is seeing some clients shift from commodity swaps to options, as locking in elevated prices on a swap is often less palatable, but the disaster protection offered by caps still allows room for downside participation.
For more guidance on current market conditions, economic drivers and indicators, recent communication from the Fed, and potential strategies corporations can employ to manage financial risk in the current environment, Join me and Amol Dhargalkar for our Semiannual Market Update webinar on Thursday, February 3 at 2:00 p.m.
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Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.22-0027
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