Steepening yield curve increases cost of GBP interest rate hedging

With the Bank of England’s base rate still pegged at a historic low of 0.1%, these moves are due to a market-driven steepening of the yield curve rather than any change in monetary policy. Far from suggesting rate rises, members of the Monetary Policy Committee have been debating whether to use negative rates or more quantitative easing to stimulate the economy. But underpinning this policy response is the assumption that inflation will remain unproblematically low, allowing the BoE to keep monetary conditions at “emergency” levels.

This assumption is now being questioned. Unlike in previous downturns, average household cash balances have increased during the pandemic due to a variety of government support measures. Meanwhile, lockdowns have severely constricted supply in a number of sectors, and bottlenecks in commodities and shipping are already becoming apparent. As vaccines allow society to reopen, the release of pent-up demand could well combine with restricted supply to increase prices. A number of economists warn of structural factors that could turn such an inflationary burst into a longer term trend.

Worries about inflation cause the yield curve to steepen for two reasons. First, investors are betting that the MPC would react to sustained price increases by raising the base rate higher than currently anticipated. As a result, lenders demand a higher interest rate for longer term borrowing. Second, gilt markets fear that the BoE’s quantitative easing programme would be reduced or halted, meaning that government bonds would lose a key buyer. This reduces prices for longer term bonds, again driving yields up.

It is hardly unusual for an economic recovery to be heralded by fears of inflation and bond market jitters. This time, though, the rebound is taking place after a combination of monetary expansion and government spending that has no peacetime precedent. It is unlikely that interest rates have just had their last dramatic month of the year.

What does this mean for interest rate hedging? Many borrowers use the five-year swap rate as a proxy for the cost of debt in their investment cases for new deals. Appraisals that were conducted in January now require material changes to their assumptions. Extended completion timetables also raise justifiable concerns that funding costs could increase further in the coming weeks and months. As a result, pre-hedging is being considered in many circumstances – either through flexible options or forward hedging.

Investors had no shortage of risks to worry about coming into 2021, but the prospect of higher interest rates was not one of them. Given the dovish noises emanating from central banks around the world, this is unsurprising. But recent weeks have provided a vivid illustration of the limitations policymakers face in controlling real funding costs. Ultimately, it is the market’s view of interest rate risk that determines borrowers cost of funds – not central banks’.