In a recent webinar, representatives from the PNC Capital Markets Derivative Products Group, part of PNC Capital Markets LLC, discussed the ongoing uncertainty in the interest rate environment and provided some insights on hedging strategies borrowers can adopt to help manage risk.
- The Federal Reserve continues to grapple with the challenges of high inflation against the potential for slowing growth that results from higher interest rates, which has led to continued ambiguity for the future.
- After the Fed’s most recent interest rate hike in May, there has been significant volatility in expectations for interest rates going forward.
- Strategies for borrowers to manage risk in the current interest rate environment may include forward-starting interest rate swaps, interest rate collars, and cross-currency interest rate swaps.
- of the Managing Interest Rate Risk During Periods of Uncertainty webinar.
Macroeconomic and Interest Rate Environment
Patrick Zann, managing director for PNC’s Derivative Products Group, began the discussion with an overview of the macroeconomic and interest rate environment in the United States. He compared the Federal Reserve’s current rate tightening cycle with one that took place from 2004 to 2006, noting that the previous cycle largely achieved its aims because the Fed was effective in telegraphing its series of intended rate hikes to the market. This has not been the case in the current tightening cycle, and the ongoing ambiguity of the Fed’s forward path continues to create significant uncertainty.
Zann also provided some insight into the current status of the Fed’s effort to manage its dual mandate of employment and inflation.
- Employment: Although the pace of job growth in 2023 has slowed when compared to the prior couple years, the labor market remains extremely resilient. The unemployment rate in April dropped to 3.5%, matching the lowest level since 1969. Since the time of the webinar recording, labor data in May showed the economy added 339 thousand jobs, once again significantly exceeding estimates. Unemployment ticked higher to 3.7%, but U.S. employers increased the need for workers by 400 thousand to a total of 10.1million available jobs. The increase pushed the ratio of job openings per unemployed worker to 1.66. Labor Force Participation held steady at 62.6%, the highest level since March 2020.
- Inflation: The Fed’s attempts to combat inflation are taking effect, but core price increases remain well above the Fed’s target of 2.0%. Wage growth is part of the challenge for the Fed, as average hourly earnings remain elevated. May showed an increase of 4.3% year-over-year, providing continued fuel for consumers to spend.
As a result of the combination of these factors, at its meeting in May 2023, the Fed voted to raise the Federal Funds Target Range to 5.00-5.25%. According to Zann, PNC economists anticipate the Fed will hold rates steady through the end of the year and will not begin cutting until 2024. Zann also noted that, even though this is the view held by many economists as well as the Federal Open Market Committee (FOMC), at the time of the webinar the market was pricing in two or three rate cuts by the end of the year, following by an aggressive number of rate cuts in 2024 and beyond. These market expectations have created what could likely end up being an overly inverted swap yield curve.
Applicable Hedging Strategies
The current outlook, particularly given the inverted yield curve, presents some opportunities for borrowers, but a challenge for many is how to translate this into an actionable plan. Adam Goff, managing director for PNC’s Derivative Products Group, shared some hedging strategies to protect against risk and capitalize on the rate environment.
In terms of strategies, Goff noted that one of the benefits of working with rate hedging products is the ability to adjust the hedge to the particular needs of a borrower or a project. When the rate environment changes or a borrower wants to address a specific risk, targeted strategies can help manage risk within the unique aspects of the landscape. Goff highlighted several hedge structures that may benefit borrowers in the current landscape.
- Forward-starting interest rate swaps: As with a traditional interest rate swap, this tool allows a borrower to agree to pay a fixed rate in exchange for receiving a floating rate. However, in the case of the forward-starting swap, the fixed rate is calculated and set today, but the bank and the borrower delay the exchange of the interest payments until a future date. Forward hedges are growing in popularity due to both continued uncertainty about where fixed rates might be when a borrower is ready to term out or issue debt and because of the inverted yield curve. Forward-starting swaps are commonly used in loans that include an initial draw period or to manage the interest rate risk on forecasted debt.
- Interest rate collars: A zero-cost interest rate collar may be another attractive option to hedge interest rate risk as uncertainty grows around the direction of floating rates. A collar sets a maximum and minimum rate for a floating index like the Secured Overnight Financing Rate (SOFR), and within that range the borrower pays the floating rate.
- Cross-currency interest rate swaps: As the cost of borrowing in the U.S. has increased, borrowing in foreign currencies might have a comparative advantage. Cross-currency interest rate swaps, which are agreements between two parties to exchange interest payments in two different currencies, may provide a way to gain exposure to foreign interest rates. Most often, borrowers use cross-currency swaps to synthetically redenominate U.S. dollar debt to a foreign currency. It may be an effective hedging structure when the borrower is confident in their ability to generate cash flow in the foreign currency.
Implementing Hedging Strategies
In terms of how borrowers are choosing to deploy their hedging strategies, Goff noted that there is a trend toward balancing interest rate protection with some capital structure flexibility. Borrowers may choose to implement smaller, incremental hedge amounts executed over a broader timeline, rather than take an all-in approach that locks in a fixed rate on the fully borrowed amount on a single day.
These hedging strategies may take the form of layering smaller tranches, laddering/staggered maturities, or partial hedges.
Ready to Help
PNC’s Derivative Products Group can work with you to implement a capital structure and hedging plan that provides the right balance of protection, liquidity, and flexibility. Click here or contact your relationship manager to learn more.