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Ok, so maybe we haven’t seen a run up in rates like this in, oh, almost three years, but that doesn’t mean it’s time to panic. After all, we are still in a period of extraordinary accommodation, in zero-interest-rate-policy land, still enjoying the lowest rates of our lifetimes. The economy is thought to be doing pretty well right now – not the best that it can be, but growing steadily and generating jobs at a modest clip – and apparently that’s the problem. If the economy is doing better, then maybe we no longer need so much stimulus, and if we reduce said stimulus, we are surely one day closer to stopping it altogether, and reversing course.

So, what exactly did we witness last week? Plain and simple, market participants are anticipating the end to quantitative easing and transitioning to the next chapter in our recovery. Recall that this program was designed to keep downward pressure on longer term interest rates. Some would argue that the Fed was trying to provide as many people as possible the opportunity to refinance their homes and generally jolt the housing market back to life. If you understand the Fed’s dual mandate of price stability and full employment, then you know the program’s true aspiration was to continue the jobs recovery by stimulating growth, borrowing, and commerce at all levels. The Fed is approaching the day when less central bank stimulus (or none at all) will be necessary to maintain this momentum.

Just the facts. A rationale person (and we are trying to be rationale, here) would survey the current situation and review the facts before making any moves. We generally know what just happened, so what does it look like “on the ground?” Long term rates are up sharply since the recent low point on May 2nd – up more than 90 basis points on the 10yr UST to 2.54%, the highest yield since 2011. Shorter term rates have moved far less, but the 2yr UST has moved up 20 basis points to nearly double at 0.37% in the same period. The curve steepness is greater, witnessed by the 2s – 10s spread, up more than 70 basis points to 2.16%. Importantly, though, the shortest rates, upon which most USD floating rate loans reset – 1m LIBOR, 3m LIBOR, and Fed Funds Effective – are not up at all in the same timeframe. This belies an important fact: The Fed has not removed any stimulus yet.

A key observation. To be sure, the Fed actually purchased more than $4.5bn in bonds just since Wednesday’s FOMC announcement. We did not experience the run up in rates because of a Fed hike of any kind. A key observation, though, is that while the Fed can control stimulus and liquidity (if you wish to call it control), the Fed cannot control investor sentiment, perception, and expectations. That means that market participants have run up rates, and they can either run ‘em up higher, or run ‘em back down to the ground. Either way, this rate movement is very real, and impacts pricing on every financial instrument you would use in your business to manage interest rate risk

The case for higher rates. The recovery is moving along and gaining strength. The slack in the economy that has so stymied the Fed and blunted its policy tools over the past few years, is slowly being taken up by private industry. The Fed wants nothing more than to return to simpler times, with a smaller balance sheet, a capable fed funds target rate, and a seldom used (yet stigma-free) discount window. If talk and speculation about tapering leads to higher rates, imagine what will happen when the Fed finally acts to reduce and withdraw stimulus. Like the political debate a few years back, calling a reduction in the rate of increase in government spending a “cut,” so too the Fed’s moves will be perceived as “tightening,” even as it continues expansionary policy by buying bonds (albeit less and less until one day stopping altogether). Only a well-choreographed and highly communicative process, it seems, can prevent rates from rising during this stage of recovery.

The case for lower rates. Like the right choice of words to calm investors when Chairman Bernanke speaks, “inflation” is proving to be equally elusive and virtually nonexistent right now. The general lack of concern about inflation has meant everything – allowing the Fed to focus squarely on job creation and massive stimulus, seeing very little in the way of overheating in the economy over the past four years. Without inflation, and until meaningful decreases in unemployment are achieved, the Fed has no reason to change course, and has even said so on several occasions. Even though investors anticipate a rate move and higher long term rates eventually, market participants could quickly revise their estimates of “when” this happens, as the Fed maintains course due to real incoming data. In this scenario, rates only return to recent lows if market participants read the lines, and not between them, in the Fed chairman’s speeches and statements on the economy.

What should I do? Paying more is painful. Many people are kicking themselves for not hedging last month when they had the chance. If you feel that you may have “missed the boat,” you are not alone. So, what should you do now? It all depends on your view on interest rate risk. A hedger has no real expectation that he or she can call the bottom, or the top, or enter or exit the market with precision. Hedgers focus purely on the uncertainty of it all, and eliminate this uncertainty by locking in or limiting interest income or expense as soon as underlying risks are identified, quantified, and deemed to be hedgeable. Hedgers get their risk taken care of and move on – even now, in the higher rate environment – because hedgers admit they just don’t know where the market will go. However, if you believe you know where rates are likely to go, then you should act on those views and “watch and re-assess.” Enjoying low short term rates is one thing, but having a trigger that tells you that “it’s time to hedge” is the best response to prevent the situation from getting out of hand. Even if you believe that rates will come back down, you still should have one or more triggers to help you in the event rates don’t go the way you think they will. In all of these cases, you won’t miss the boat on hedging; the bottom, maybe, but not the boat!

If you want to learn more about the situation and your interest rate risk management options, we would welcome your call, and strongly encourage you to tune in to our upcoming webinar (Market Update: Fed Up)on the matter!