What do you do when rates drop sharply?

Last week’s market volatility took us for a wild ride. Coming off Federal Reserve Chair Jerome Powell’s testimony in front of Congress the week of March 6, the market was braced for a hawkish Fed ready to raise rates until inflation cried uncle. By close of business Wednesday, March 8, the market was pricing in a 70% chance of a 50-basis-point hike at the upcoming Fed meeting and SOFR to peak at 5.67% in August. Come Friday, March 10, this narrative was starting to show some weakness with the distress of Silicon Valley Bank. By the morning of Monday, March 13, rates were in free fall as we were wondering if Fed policy decisions had finally “broken” the economy. By close of business Friday, March 17, the market was pricing in no chance of a 50-bps hike this week, a 70% chance of a 25-bps hike, and a 30% chance of no hike.

March 13 was Chatham’s busiest day of the year as our clients were calling us to pull the trigger on hedges of both short- and long-term rates. Whether looking to purchase a cap extension coming down the pike or looking to lock in a 10-year rate for an upcoming bond issuance, clients likely saw a “deal” as cap pricing was, in many cases, less than half of what it was a few days prior, and 10-year rates ended the day down by 14 basis points. By the end of the day, we had a lot of happy clients who were able to get their trades done, and others who wished they had engaged with us sooner to better position themselves to trade quickly.

On Tuesday, those who traded felt doubly satisfied as the market corrected, bonds sold off, and rates went back up — it looked like they successfully “bought the dip” the day before. Then Wednesday came, with rates dropping again on news of Credit Suisse’s troubles, leaving some wondering if their Monday execution would have been even better if it had been delayed a few days. Looking at the table below, which shows the end of day 2- and 10-year rates, we get a stark read on how volatile the week was. We saw a similar story with cap pricing, with some meaningful day-over-day pricing fluctuations.

These conditions led to some interesting debates with our clients (and amongst ourselves) on how to think about interest rate risk management in this type of environment. When you see favorable moves in pricing, do you move opportunistically and try to lock them in? Or should you be worried that you’re trying to catch the falling knife and that you may miss out on better pricing to come? Here are our takeaways from last week:

• Be policy-driven: We’ve observed that some market participants react as much to price movements as to the absolute level of pricing — when rates/pricing fall, they rush to “get in on a good deal.” While we often see value in opportunistic hedge execution, this is best done in the context of a more thoughtful risk management approach. The clients we work with who have the best outcomes recognize that hedging and risk management is a process and not a point in time decision. They have decision frameworks that don’t leave them making decisions entirely in the moment of a significant market move. This includes having solid grounding in the objectives and risk exposures of underlying investments, knowing one’s own risk tolerances, and having already evaluated alternative risk mitigation approaches (for more on risk management frameworks, see this piece).
• Be prepared: There’s no debate to be had if you can’t trade. Putting a hedge in place is not always a turnkey exercise. For over-the-counter (OTC) trades like interest rate caps and swaps, a dealer bank can’t trade with you if you haven’t completed their onboarding process, which can often take a few days in the case of a cap or a week or more in the case of a swap. Exchange-traded products, like swap futures, may be a little more accessible, but still can’t be executed at the drop of a hat. Our clients with the most satisfactory outcomes this week were ones that had worked with us in advance to be able to trade on short notice, a prudent approach in these volatile markets.
• Rates aren’t the whole story: Pricing on Monday, March 13 was (relatively) favorable for both caps and swaps. Rates fell and the market for volatility remained liquid, so pricing for both declined. Wednesday, March 15 was a different story. Even as rates were declining again, dealer banks that sell caps were having a hard time “purchasing” volatility to hedge the exposure they were taking on when selling options like caps. This had them backing up on pricing even as rates were falling. This dynamic can be common in volatile markets and pricing on options products like caps can often behave in non-intuitive ways.
• Don’t miss the forest for the trees: In volatile markets, bid-ask spreads widen. Our clients are, understandably, sensitive to how wide these spreads are on their trades as it’s one indicator of how good a “deal” they’re getting at the moment of trade. We endeavor to ensure that these spreads are as tight as possible for our clients, but, in a volatile market, you may need to be prepared to pay a wider spread to achieve that better absolute level. Market participants don’t want to miss a 15-basis-point improvement on a swap rate because the mid-offer spread on the trade gapped out from a quarter basis point to one basis point.

While our crystal ball has never been right more than half the time, we are encouraging clients to be prepared for more volatility to come. With the bank distress we saw this past week, we may be starting to see the first meaningful signs of how Fed policy decisions might impact the economy in a negative way. The market may begin to react even more dramatically to economic data and other news that suggests the appropriateness of either further tightening by the Fed, or a need to loosen monetary policy. This volatility could present additional opportunities to hedge at pricing consistent with investment objectives and individual risk tolerances, but we’d caution clients not to assume they can call the "bottom”. In this volatile environment, we’re helping clients make sure they’re tracking pricing on hedges they want to execute, and they’re ready to trade quickly if prices hit attractive levels.