Interest rates quietly rise as the Texas energy crisis dominates headlines
- February 22, 2021
Corporates | Kennett Square, PA
SummaryLong-term interest rates continued their upward march last week, with the 10- and 30-year Treasuries hitting highs not seen since February 2020. Dovish FOMC minutes combined with lower infection and hospitalization rates, supporting overall investor optimism even amid the Texas energy crisis.
The Texas energy crisis dominated market headlines over the past week. With over 4.4 million outages lasting multiple days on a near-collapse in energy generation and distribution, state of emergency themes such as boil water requirements and empty grocery store shelves highlighted acute problems for the largest state energy producer. Meanwhile, long-term interest rates rose to their highest levels since almost one year ago, with the 10- and 30-year Treasuries hitting 1.33% and 2.12%, respectively. Inflation expectations appear to be a primary driver, coupled with the ongoing themes of a dovish FOMC and improving COVID-19 statistics.
Texas energy crisis impact on commodity prices
As sustained sub-freezing temperatures took hold of Texas’s pipeline infrastructure, capacity constraints on gas pipelines limited the amount of gas available for power generation in the colder temperatures. Given the unique nature of Texas’s independent power grid, minimal power could be imported into Texas from other states. This distribution curtailment coupled with reduced generation from frozen wind turbines resulted in power outages for over 4.4 million homes. At a typical production level of roughly 75,000 megawatts in traditional/non-renewable power generation, at the peak of the crisis as much as 25,000 megawatts were unavailable. Short-run natural gas and power prices in turn skyrocketed, with power rising from $22 per megawatt-hour to as high as $9,000 per megawatt-hour in some cases. As the crisis abates, these short-term dynamics are likely to subside and the market will turn to analyzing the longer-term impacts, particularly on oil.
Reports of between three and four million barrels per day of oil refinery output went offline last week, resulting in major impacts to global supply chains. In context, oil prices have surged upward in recent weeks, continuing to price upward even during the initial days of the Texas crisis, peaking at $65.40 per barrel. Prices eventually slipped to between $62–$63 per barrel, but the broader themes driving commodity prices have held true: OPEC continues to limit supply, while expectations for the post-COVID economy signify future demand, putting upward pressure on prices.
(Related insight: "Using commodity collars to manage market volatility")
Inflation continues as major market discussion item
With current year-over-year inflation still showing moderate levels around 1.5%, the market continues to focus on expectations of inflation over the medium term. The Texas crisis could be one factor continuing to drive expected inflation, with supply constraints expected to push prices up. Indeed, the 5-year inflation breakeven rate rose again over the past week to over 2.22%, the highest level since March 2018. FOMC minutes released this week support the market inflation narrative, with committee members stating they won’t be ready to taper asset purchases for “some time” and that they won’t react to temporary inflation measures. The IMF came out with a piece Friday suggesting the risk of inflation following expected further government stimulus. Finally, improving COVID-19 statistics — with lower hospitalizations and increasing vaccinations — corroborate the market expectation for aggregate demand growth in coming months.
Hedging impacts: pre-issuance hedging and cross-currency swaps
For companies hedging interest rate risk, analyzing capital structure, and seeking to minimize interest expense, the above market events have shone the spotlight on pre-issuance hedging and cross-currency swaps. With many companies planning future fixed rate debt issuance, further steepening of the yield curve has illuminated the concern of higher cost of debt, prompting an urgency to lock rates now. Turning to cross-currency, the rise in USD rates against flat EUR rates is widening the differential that can be captured in a cross-currency swap. For companies looking to create synthetic EUR interest expense, material interest savings can also be accrued given this widening differential.
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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.21-0050
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