Recent Fed activity and its impact on corporate hedging
- November 9, 2020
Corporates | Kennett Square, PA
Several Fed actions support low short-term rates for the next few years. Despite this expected rate stability, corporates should understand the nuances within these actions, the implications of possible future Fed activity, and the hedging strategies that apply in this environment.
- In the September release, FOMC committee members unanimously agreed rates would stay near zero in 2021, and all but one governor agreed rates would stay at the lower bound through 2022.
- On longer-term rates, the Fed has continued to apply downward pressure to the longer end of the yield curve through continued quantitative easing, the buying of longer-term securities in the open market.
- As corporations have given their interest rate risk and debt capital structure a fresh view within the Fed’s current stances, several hedging trends have emerged.
Since the onset of the COVID-19 pandemic in the United States, the Federal Reserve has taken extraordinary measures to fulfill its dual mandate of full employment and stable prices. Many of those measures consisted of lending programs to quickly support market functions during the initial period of market turmoil. From a monetary policy perspective, the Fed has taken several actions that all but guarantee short-term rates to be low for the next few years. Despite the tacit guarantee of rate stability, corporate treasurers and CFOs should be aware of the nuances within the Fed’s actions, understand the implications of possible future Fed activity, and consider what hedging strategies apply in the current environment.
Beyond the dots: Average inflation targeting and the employment picture
Upon the quarterly release of the Fed’s dot plot, where FOMC members anonymously postulate their short-term rate expectations for the near term, the market routinely resets its own rate expectations based on the Fed’s forward guidance. In the September release, committee members unanimously agreed rates would stay near zero in 2021, and all but one governor agreed rates would stay at the lower bound through 2022. 2023 saw only a handful of governors suggesting modest rate hikes.
Taking the low-rates commitment a step further, the Fed recently adjusted the language surrounding its inflation targeting, which will now target an average two percent inflation, rather than discrete two percent inflation. This means that inflation could persistently run over two percent without a Fed rate hike, given how long inflation has remained below the Fed’s two percent target. A number of factors could drive future inflation, such as a resurgence of U.S. and global economic activity. However, the fact remains that inflation had been subdued even before the pandemic. As seen in the chart below, the three-year moving average of core PCE inflation has not eclipsed the two percent mark since the period surrounding the 2008 financial crisis.
Another new dynamic the markets are grappling with concerns the Fed’s handling of employment data. In the past, when the economy rebounds out of recession territory, the Fed has hiked rates concurrent with unemployment falling to combat future inflation. In the current environment, the Fed seems to be taking a more dovish stance. Fed Vice Chair Richard Clarida said as much in a recent speech, noting that employment data in isolation would not drive a change in policy:
“A low unemployment rate by itself, in the absence of evidence that price inflation is running or is likely to run persistently above mandate-consistent levels or pressing financial stability concerns, will not, under our new framework, be a sufficient trigger for policy action.” Fed Vice Chair Richard Clarida
Additional Fed tools: short- and long-term rates
While the Fed has brought short-term rates to near zero, it has yet to follow its European and Japanese counterparts by bringing rates below zero. Although market participants and the press continue to bring up the topic, the current composition of the Fed remains resolute in its commitment to keep rates above zero. Fed Chair Jerome Powell on numerous occasions has stated the Fed is “not even thinking about thinking about bringing rates below zero.” This “zero bound” has been respected by the markets, with the LIBOR curve staying comfortably above zero. For brief moments, the Fed Funds futures curve has dipped below zero, but that is viewed more as a technicality, with some investors hedging the slim likelihood of negative rates happening in the U.S.
On longer-term rates, the Fed has continued to apply downward pressure to the longer end of the yield curve through continued quantitative easing, the buying of longer-term securities in the open market. If the Fed wanted to be even more targeted on longer term rates, it could implement yield curve control (YCC), whereby a central bank targets a particular yield at a particular tenor, and buys whatever quantity of securities is necessary to maintain that yield. Fed governors have discussed the topic, but market participants seem to doubt the Fed would take that step. Not only has YCC had inconclusive results in Japan, but also there is significant credibility risk if the Fed were to commit to a particular yield only to find a need to alter rates in the future under a different economic landscape.
As corporations have given their interest rate risk and debt capital structure a fresh view within the Fed’s current stances, several hedging trends have emerged. First, accompanying the low rates environment has come record low volatility in certain parts of the curve; some corporations have taken advantage of the low volatility to purchase interest rate caps at lower premiums than ever before. In other cases, treasurers have seen how low swap rates are and elected to lock in such historical low rates, in many cases hedging longer (e.g. 10 years) than they may have in different market environments. For companies considering any fixed-rate debt issuance, pre-issuance hedging has been an effective strategy, using forward starting swaps to lock in the market component of their bond financing, often at record low levels. Finally, in some cases swapping fixed exposure to floating via swaps has allowed companies to effectuate a desired fixed-float mix within their risk management policies.
If your company is considering any of the alternatives above, contact Chatham Financial to discuss the latest market dynamics and how your organization can employ these strategies to effectively manage financial risk within your specific profile.
Talk to Chatham about interest rate hedging strategies
Talk to a hedging practitioner about the implication of recent Fed activity on your hedging program.
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.20-0441
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