Flattening Yield Curve Provides an Opportunity
for Pay-Fixed Interest Rate Swaps

In the weeks following the United States presidential election, longer-term rates rose due to the prospects of economic growth through tax reform and infrastructure spending policies discussed during the Trump campaign. Longer-term rates have since fallen as a Congressional focus on healthcare reform has delayed progress in the proposed fiscal policy actions, causing market participants to revise their expectations for the timing of these stimulative fiscal policy programs.

At the same time, the Federal Open Market Committee’s decision to increase the target range of the federal funds rate by 25 basis points in both March and June of 2017 has driven shorter-term rates, namely 1-Month U.S. Dollar LIBOR, higher. The combination of a drop in longer-term rates and an increase in shorter-term rates has caused a flattening of the yield curve since the beginning of the year.

  January 2, 2017 August 15, 2017 Year-to-Date Change
1-Month LIBOR 0.77% 1.23% 46bps Increase
5-Year US Swap Rate 1.97% 1.89% 8bps Decrease
10-Year US Swap Rate 2.34% 2.22% 12bps Decrease

*Source: Bloomberg

As seen in the above table, the movement in shorter and longer-term rates since the beginning of 2017 demonstrates the flattening of the yield curve. Looking at the short-end of the yield curve, the 46bps increase in 1-Month LIBOR over the past few months matches the FOMC’s tightening monetary policy action of increasing the target range of the federal funds rate by 50bps during the same period of time. Related to the long-end of the yield curve, 5- and 10-Year U.S. Swap rates have declined by 8 and 12bps respectively as market participants’ expectations for the timing of economic growth through fiscal policy actions have been delayed.

For entities with variable rate debt capital, a pay-fixed swap synthetically converts this variable rate debt to a fixed rate, extending the duration of the debt and hedging exposures to increases in short-term variable rates. The rise in shorter-term rates coupled with the drop in longer-term rates in recent months has reduced the difference between the fixed rate and the current variable rate benchmark on a pay-fixed swap. As a result, this smaller difference provides an attractive opportunity for entities seeking to hedge exposures to short-term variable interest rates via longer-term pay-fixed interest rate swaps.

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