Transcript:

Operator:

So now without further delay, let's begin today's PNC Advisory Series webinar, again, "Preparing for Rising Interest Rates." It's my pleasure to introduce your moderator for today, and that is James Bernier, Executive Vice President and Head of Derivative Products Groups. Jim, with that, you have the floor.

James Bernier:

Terrific. Thanks, Greg, and good afternoon, everyone, and welcome to our PNC Advisory Series webinar, "Preparing for Rising Interest Rates," and thanks for joining us today. As Greg mentioned, my name is Jim Bernier. I run the Derivative Products Group at PNC, and I'll be the moderator for today's presentation.

Our topic is particularly timely, given the many challenges and uncertainties we face as we begin 2022, including high inflation, a tight labor market, continued pandemic uncertainty, a Fed that's poised to raise rates for the first time in 3 years and, of course, a new challenge emerging just today with the rapidly evolving situation in the Ukraine and the associated geopolitical uncertainty.

To help make sense of it all, we're excited to have a talented group of experts from our Derivative Products Group as our presenters today. Todd English is a Managing Director and a Senior Derivative Trader on the Trading Team; Robert Leonard is a Senior Vice President and a Senior Derivative Marketer on the Sales Team; and Tina Hwang is a Senior Vice President and the Derivative Sales Manager. They'll discuss the current economic, rate, and geopolitical environments and illustrate some risk management techniques that your company can use to manage exposure. Just to reinforce what Greg mentioned, we're going to facilitate a question-and-answer session at the end of the presentation, and you can submit questions any time throughout the presentation using the question widget found at the top left of your screen.

So with that, let me turn it over to the team, and they'll take us from here. And again, thanks for joining us. Todd, I'll hand it over to you to begin.

Todd English:

Hey, thanks, Jim, and I'd like to welcome and thank everyone for joining the call today. As Jim mentioned, everyone is trying to make sense of the situation in the Ukraine, both from the immediate humanitarian perspective and what the crisis means over the longer term. So we'll start by trying to address some of those issues.

Just to level the playing field, I'm a simple rates trader, and so I'd be way out of my depth in trying to discuss the geopolitical tensions with regard to political or military implications of the events that are unfolding. Rather, I'll try to stay in my lane and focus on the current market reaction and the expectation.

If you're like us and you have CNBC playing in the background, you've seen some of the dramatic market moves today. The initial market reaction to situations like this is always an immediate flight to quality, and we saw that earlier today with yields on the 10-year falling by nearly 15 basis points on the initial headlines. Investors are trying to figure out a way to fight against uncertainty, so it makes sense to move to more safe-haven assets. Similarly, if you're watching the CNBC scroll, you're seeing a lot of red across the board from equities. But I want to try to put things into some historical perspective, and the best reference that we have right now is what happened during the Russian annexation of Crimea.

First off, I'm sure it's no coincidence that Crimea happened on February 20 of 2014, which is nearly 8 years ago to the day. When we look at that market reaction, we had the S&P actually close up on the day by 0.6%. We had 10-year yields close down by roughly 5 basis points. But when you roll forward 60 days, the S&P was actually up nearly 2.4%. A little bit difficult to compare apples to apples on the 10-year because the Fed was in the middle of its taper program at that time, and that had notable impact. But as we sit here, nearly two-thirds of the way through the trading day, and I try to take a quick glance over at the screens, equities are well off of their inter-day lows that we saw very early in the session, 10s are now only down about 6 basis points on the day, and let's see, the WTI is only up $2.00, Brent is now up about $2.60 on the day. And again, both of those were at or above $100 around 9 o'clock this morning.

So the takeaway is after the shock of the initial headlines, markets do really begin to question what the impact actually is. And there's been three key areas that we've been discussing here on the desk and how we think about how to consume and absorb the information coming out of Russia.

First is the direct economic impact. So the sanctions themselves that the US is going to impose on Russia are really probably not going to have much of a direct impact on the US economy. The reality is, is Russia is just not a material trading partner with us.

Second, we do want to consider how the Russian invasion is going to impact our trade with western Europe. And this does start to weigh a little bit heavier in the economic question. The immediate thought is Europe is likely to have higher energy costs, which will leave less money available to import goods from the United States. At the same time, their export cost to the US is likely to increase as well, again due to those same energy costs. Although it has been shrinking, we do actually still have a trade deficit with the EU, so we're viewing this impact to be net inflationary towards the US.       

Finally, the third thought that we have here is the carry-on impacts from higher energy prices in the US will likely influence the cost of oil here domestically. As I mentioned, we are up on the day for oil. Trying to put things into perspective, though, prior to this invasion, there were already a number of white papers circulating in the markets trying to make sense of what the inflationary impact would be if oil was at $100 or $105 a barrel. So there was already some expectation that higher oil prices were already built into the market.

We have to admit that the Fed tends to discount oil prices. They like to look at a lot of the inflation reads ex energy, and that will discount some of the short-term volatility that we have. If WTI hits $130 or $150, certainly that's going to move the needle for the Fed. But since there's already a lot of forecasts out there that consumers were expecting to pay higher prices at the pump, to a certain extent we're just realizing some of those expectations today.

So that was really a lot of exposition to basically state that the inflation in the economic outlooks that we have today are more or less pretty close to the same that we had yesterday.

So to move forward and start to talk about inflation, there's really no other way to say it besides to state that it's running high. Today's GDP price index ran a touch higher than expectations, firm in the belief that inflation is likely to run hot for quite a while, still.

I want to start the discussion on inflation not talking about supply chain issues. It's not because those are not important, but really, we're seeing that label being applied to a wide variety of problems. Instead, I want to start looking at inflation by looking at the demand side of the equation, which seems to be overlooked a lot in a number of the inflation discussions that are being had.

Demand, like inflation, is running high. It's been strong throughout the pandemic with many sectors showing upticks. And that's not just from autos and houses. It's being put forth in a wide area of goods and services. Probably more importantly, we're seeing demand showing a lot of elasticity, and consumers aren't slowing down their purchases as the prices are rising.

 And it's really this demand aspect that we feel the Fed has misjudged since the midsummer period through today. If you look at the comments from the Fed around this time last year, which it seems like forever ago, but that is really just when the vaccines were starting to hit the general population. The Fed was talking about and predicting inflation. They weren't predicting 7% CPI, but they did know that inflation was going to rise. And I think it's easy to forget that amid headlines or the contributors that we see on CNBC that are saying the Fed is behind the curve. And there's two points that I want to make here with regards to the Fed potentially being behind inflation.

First, there's been a number of white papers out, both by the Fed and by private sector economists, trying to gauge what the impact of pandemic support programs had on demand, and just as importantly, what would happen to demand as these programs ended. They all basically reached the same conclusion, which is pretty basic, Econ 101 stuff. Either people would have to reenter the workforce to support this level of demand, or demand will taper to match lower household incomes. The Fed, quite honestly, has been expecting an uptick in labor force that just hasn't happened yet, and to a certain extent, this is the reason the Fed has been caught holding onto their transitory tag, really for much longer than they should have.

The second point that I want to make here is that even amid all of the calls that the Fed might be behind inflation, we're really not seeing anyone calling for runaway inflation at this point. If you look at the Fed's surveys--I'm sorry, if you look at the surveys from private sector economists, most are looking for inflation to moderate some time in the second half of '22 to the first half of 2023. PNC's Econ Team is calling for core PCE to be roughly 3% by the end of the year, which is down pretty considerably from the current level of 4.9%. It's really almost that the Fed has gotten the timing call wrong, but not so much the underlying issues wrong.

Circling back a little bit here to supply chain, the trading desk feels that the market really needs to review the appropriateness of this label. As I mentioned, it feels like this is being used to generically cover anything from raw materials cost increases to shipping delays to manufacturing constraints. Compared to, let's say 18 months ago when it was really only applied to constraints and bottlenecks directly stemming from the pandemic, and while those things are still present, we're hearing some anecdotal reports that several sectors would have had trouble meeting demand even at pre-pandemic capacities. And we think it's really important to parse that portion out, as that really speaks to a growth story problem. And that's really somewhat indicative of the healthy underlying economy.

Finally, to finish the inflation discussion, I want to talk about wage inflation, and I'm sure everyone on this call is being impacted by the trifecta of higher wages, employee turnover, and the lack of qualified applicants. When discussing the Great Resignation that we're in, there's really two aspects to this. First, we do have a shrinking labor force, and I'll cover that in a little bit more detail later.

The second aspect is the employee turnover resulting from job changes. Chicago Fed released a study on this earlier this month, and they're estimating that those searching for new work while currently on the job is increasing inflation by up to 1.1%. While I know a lot of us like to think of this as being analogous to input prices going up as we're all fighting for limited resources, there's a different way to think about this problem, and that is we're all trying to meet a lot of demand that we're seeing now and trying to hire for that demand. I'm not saying that wage inflation is going away in the future, but again, we really need to think, are you hiring now to meet levels of demand that were present prior to the pandemic, or are you looking to hire now to meet increased demand that you've seen since the pandemic? Again, the latter really speaks more to the health of the economy and a little bit less to the labor shortage that we're currently experiencing now.

So finally we can get to the point where we can really start talking about--sorry, this slide didn't move forward--sorry, let me restart again. We can now start to really start to talk about what is going to go on with the rate market. As we mentioned when talking about Russia, the Fed is going to hike. Our Econ Team is calling for a 25-basis-point hike in March, which we agree with here on the desk, as does the market. Over the long run, PNC's Econ Team has seen a total of five hikes in 2022. The market is a little bit more aggressive, pricing in six hikes for the remainder of this year. We also see three more hikes in 2023, which really has us putting the terminal Fed fund rate somewhere in the 2% to 2.25% area.

We do have to talk about Bullard, who previously this month said that he wanted to go 50 in March and a total of 100 by June. Immediately following those comments, the markets moved up to show roughly 80% odds of a hike of 50 in March but then quickly retreated from those levels. Quite frankly, the Fed hiking 50 next month doesn't really fit in with the character of the Fed. They tend to like to go more slow and more predictable.

As an analogy to that, the Fed is still currently buying bonds, as they didn't want to end their quantitative easing program too abruptly. Rather, they wanted to make time for the markets to absorb the change. Compared to Bullard wanting the Fed to be at 100 by June, the Fed could get to 100 by July through hiking at each of the next four FOMC meetings. It's really not that different to where Bullard wants the Fed to be, particularly when you think about how long it takes for Fed hikes to trickle through the economy. But by going 25 at each meeting, they'll really preserve the character of the Fed, go slow and steady, and it also helps the Fed preserve a little bit of optionality in case they need to speed up or slow things down if they need to. Again, they're trying to avoid the shock that's going into the market.

We do get another employment report and another CPI print prior to the March 12 meeting. And while we won't say that the bar is impossibly high for the Fed to go 50 in March, it is quite high. And we would really need some data that is unpredictable or off the chart for us to get there.

I do want to inject a small sidebar here, and that's because traders and commentators often lose sight of where our place is in the food chain here. What we--and by "we" I mean traders like myself or contributors on CNBC or market commentary write-ups--we often seem to think that the Fed is either influenced by or somehow going to react to what markets are predicting. The way the world actually works is that traders are investing based upon Fed expectations, but the Fed takes action based upon economic data.

And it's not just the Fed, but all central banks. We had a recent example of this back on January 26. The Bank of Canada held their rates constant, but markets were pricing in something like a 65% odds of a rate hike. So again, the Fed is going to be data-dependent. That's a phrase they use ad nauseam any time they speak, and they're really not going to look to the market to try to guide their notion of what they think they should be doing.

Looking at longer tenure rates, we're going to focus here on the 10-year Treasury yield. Tens have been hovering around 2% lately, and that 2% level is a bit of a psychological level here for traders. Yields rarely move orderly through 2%. Rather, we tend to sneak up to that level and then retreat. And when we do decide to move through 2%, it tends to happen pretty aggressively.

For a few examples of this, we have to go back to January of 2016. At that time we were above 2%. We bounced off it a few times, but when we did push through in February of 2016, we pushed through all the way to 1.75%. We saw the reverse of this happen later in that year back in November of 2016. Yields were basically still hovering around 1.75%, and when they pushed through, they went immediately back up to 2.25%.

One last example was back in 2019, again pre-pandemic times. Once again, we were tiptoeing along a little bit higher than 2%. But when we pushed through, we pushed back down to 1.75%. Since February of this year, 10s have been trading mostly between 1.90% and 2%. And again, it feels like the 10s don't want to be in this situation. They probably would feel a little bit more comfortable either at 1.75% or 2.25%. Even after this morning's cavitations, we're sitting here--actually, we've ticked up a touch higher--we're now sitting here at 1.95%. So we're getting the sense on the trading desk here that the true home for 10s is probably more likely to end up at 2.25% than it would be to retreat back to 1.75%

And the balance sheet reductions that everybody's expecting the Fed to announce are likely weighing on the market at the moment. As previously mentioned, the Fed is still buying bonds, and it's only going to start winding down their program in the upcoming meetings. There's a split in the market as to whether it's going to be a March announcement for balance sheet reductions with a May implementation date or potentially a May announcement with a June implementation. But the markets are sitting on eggshells, waiting for the Fed to actually announce that. And around that time, we do expect the Fed--I'm sorry--we do expect 10s to probably move into that 2.25% area.

At this time, let's turn to the slope of the yield curve, and there's always a lot of talk about the potential for 2s and 10s to invert--in other words, show a downward-sloping yield curve. For those on the call who may not know, there's a very strong correlation that when the yield curve is inverted, it's a very good predictor of a pending recession. This time around, we think 2s have probably moved very aggressively in response to the inflation and in response of anticipated Fed moves, and we've seen that 2s-10s spread collapse down to, I think we're around 35 basis points at that moment, whereas 10s have been anchored, as we're expecting the Fed to make some of these balance sheet announcements.

We'll also point out here that the size of the Fed's balance sheet provides Powell with more ammunition to influence the slope of the yield curve than any other Fed president has ever had. So we're not saying that an inverted 2s-10s won't be a predictor of potential inflation. Rather, we think there's a lot of ability for the Fed to help influence the shape of the yield curve, and we might not get quite as clear of a signal for when things are turning, if they're going to turn.

But with that, I do want to take a step back and talk about the hike cycle that we covered on the prior slide. All of the economists that are out there, whether it's PNC's, the Fed's summary of economic projections, or other private sector economists that you're seeing, everybody's expecting a hike cycle to go well into 2023. Again, the Fed doesn't do that unless we have a healthy economy. There are easier ways to probably fight inflation in the more short term, if that's what they want to do, but we're really looking at a protracted and long-term Fed hiking cycle. And we do, frankly, believe that the economy can support that.

And I'm going to close out my part of the presentation with this final thought, in that part of the reason that the economy can absorb that is the smaller labor force that we currently have now. Prior to the start of the pandemic, the participation rate was hovering somewhere around 63%, and now we're hovering somewhere around 62%. The St. Louis Fed put out a white paper covering this aspect earlier this month. It was a great white paper because it basically affirmed what everyone was already thinking. We're experiencing declines in the labor force due to both upticks in retirements and also those that are choosing to focus on home care or family care and step out of the labor market. And while we probably won't get that full 1% back due to the retired population, it does indicate that there's a lot of bench strength out there that could be pulled back into the labor market.

And that has a lot of importance to the Fed that will help them support an aggressive hike cycle. There is the potential for those to be pulled back out of the sidelines and back into the labor force and help bolster the economy. And so we're not seeing any material signs that the economy is slowing down or that we're going to have any material downturns, at least through 2022 and most likely a good portion of 2023. After that, it's really difficult to predict what's going to happen in the economy. But that's our current call at this point.

At this time I'd like to turn things over to Robert. That way, he can help discuss some of the strategies that PNC could potentially offer to help protect against these uncertain times. Robert?

Robert Leonard:

Thank you, Todd. As Todd just mentioned, we are going to see a rise in short-term interest rates as the Fed raises rates, and we will generally see longer-term rates trend upward. So rising interest rates, obviously, negatively impact the cost of debt and capital as well as threaten budgeted interest rate expenses. However, they can reduce pension fund requirements due to higher yields on fixed income instruments.

An interest rate swap is the primary product that corporations and other entities use to hedge against a rise in short-term interest rates. As you see in the diagram there, an interest rate swap is an instrument in which the borrower pays a fixed rate and receives a floating rate. And then the index on the floating rate of the swap is matched to the floating rate index of the loan. So in this case, the borrower has a loan price that's SOFR plus a credit spread. Then in the swap, they're paying a fixed rate and receiving the SOFR rate. So we like to say that the SOFR rates cancel out, and then at the end, the client is paying a fixed swap rate plus their credit spread. So that's how they derive a net fixed interest rate. The swap and the loan are separate agreements, but the swap itself provides a lot more flexibility than utilizing a traditional fixed-rate loan. For example, in a swap you could hedge the last 4 years of a loan, or you could just choose to hedge a portion of your loan.

In this example, we used SOFR as an index, but also PNC could provide interest rate swaps using BSBY as an index. At the bottom of the slide there, you see indicative rates. Those were prepared yesterday, and the rates changed, as market rates change, as you just heard from Todd. But those rates show you how flat the yield curve is. So many clients are interested in going longer term on their hedges because the incremental cost of going further out is fairly low. As you see there, the difference between a 10-year swap rate and a 5-year swap rate is only 7 basis points. Interest rate swaps are a primary product, again, for clients to hedge current loans or loans that they anticipate closing within the next few days.

Many clients ask us, "What can I do to hedge against rising rates for financings that occur in the future?" Typical situations are a construction to perm loan. Many of our clients are building buildings. They have a construction loan and the permanent loan doesn't take effect until a year from now or 18 months from now. And obviously, as we just mentioned, long-term rates could rise during that time.

The other situation for public companies that issue in the bond market, again, they plan to come to market with a fixed income bond issue, let's say in the next 3 to 6 months, and again, they want to guard against an increase in their fixed rate.

Another application is acquisition finance. Again, acquisitions take a long time to close, and the rising interest rates could affect the return on investment as well as increased costs associated with a finance.

A forward swap is a swap in which we set the fixed rate today, but the start date is some period in the future. So, for example, if you expect your permanent loan to close 1 year from now, we could enter into a swap today to fix the rate for a swap that starts 1 year from today and goes for the term that you expect to do for the underlying loan. So for example, if you expect the loan to be 5 years, we are entering to a forward-starting swap that begins 1 year from today and has a tenure of 5 years.

 In the case of bond issuances, similar. The start date of the swap would be the anticipated funding date of the bond, and then when you issue the bond, clients terminate the swap and the gain or loss on the swap are set to the increase or decrease in the bond coupon.

And then lastly, acquisition finance. The closing date of the swap would be the anticipated closing date of that future financing.

In the bottom part of that slide, it gives you some indicative rates of those forward swap rates. As you can see, there is a little bit of what we call a premium for those forward swaps, but they're fairly low. Again, it's illustrating the flatness in the yield curve, so those forward premiums are fairly low. So if you were to do a 5-year swap today, it was 1.83%, but 6 months from now, that rate would be about 12 basis points higher. Those forward premiums are lower for longer-term rates. In the 10-year case, if you go 6 months forward, that forward premium is only 7 basis points.

And taken in context, those forward premiums are fairly low compared to the interday market volatility that we've been experiencing lately with the movements in long-term rates. They're sharp, as Todd just mentioned. We've seen fairly big moves for various reasons--changes in expectations of the number of Fed rate hikes and, obviously, economic and/or geopolitical events.

Now with that, there are some additional methods to hedge forward financings, and I'm going to turn it over to my colleague, Tina.

Tina Hwang:

Thanks, Robert. So Robert talked about spot fixed swap rates in addition to forward swap rates. In the optionality world, we have really two main products where clients can use options to hedge against rising interest rates. Interest rate caps are common, and we have done an advisory series on cap options.

Today we want to focus on swaptions, and a swaption is simply an option on a swap rate. It gives the swaption buyer the right to enter into the underlying swap on an expiration date at a predetermined strike rate. A swaption could be bought and sold for a premium paid or received. For today's discussion, we are hedging the discussion, so we're going to focus on being long that swaption where the buyer owns the right to enter into a fixed swap rate.

A swaption comes in two forms, a payer's swaption or a receiver's swaption. An entity wanting to protect from rising rates, which we're facing now, will purchase a payer's swaption. With the premium paid, the swaption will give the company the right to enter into a known fixed rate in the future. This removes the unknown cost of interest for the debt that they may take down. If the underlying market rate on the expiration date is lower than the strike rate of that swap, the swaption will expire worthless, and the buyer will enter into a lower market rate. There's value in that, although the premium is wasted. However, conversely, if the underlying market swap rate is higher than the strike rate, the buyer will enter into that swap rate at that strike rate, so the purchase was of value. And the economics can be determined based on how high the market rate is versus the strike rate that they've purchased.

So what are some of the applications? If you're a company bidding on a contract and the funding certainty is uncertain, or bidding on an acquisition of a company or an asset of some sort, or if your future funding is uncertain at all, a swaption can be utilized to protect from rising interest rates.

So what we have here, if you listened to the rates that Robert mentioned--the 5-, 7-, and 10-year swap fixed rates that were spot versus 6 months forward or 12 months forward, those are rates that you commit to today and lock in for some future date. Spot rates can be locked in where you're committed to that fixed rate starting today, or the forward rate. And what we've done here is picked some options premiums whereby this is all based on a notional, or the contract amount, of $1 million, and we did this for the sake of ease. If you have a $10 million consideration or $100 million, you would just adjust accordingly.

So at the bottom there, if the 5-year swap rate that Robert mentioned was 1.83%, you're not going to buy an option at the spot rate. What you want to do is take a look at the free forward premium of the 6-month forward rate at 1.95%. We move that up slightly to 2% and 2.5% so that it's around the money. And if you wanted to buy a 5-year, 6-month-forward protection on $1 million where the swap rate is at 2%, that premium, based on yesterday's levels, and this is an indication, will be $12,100. If the swap rate was adjusted upward to 2.5%, the premium comes down to $6,500.

So let's say you're bidding on a project and you needed $1 million, but you want to fund this when the contract is awarded, and the project starts in 6 months. If you commit to a forward swap rate of 1.95%, you're committed to getting that rate even if rates decline. The optionality here of buying a swaption gives you the ability to walk away from this particular fixed rate obligation. So if I'm to use the 2.5% strike rate and you pay $6,500 today and the contract is not awarded, then you've lost a premium of $6,500 by not entering into that trade, but if the market rate is higher, there is still an economic gain to it, even though your project has not been won or will be funding.

The strike rate, the higher you move up from the spot or forward rate, the cheaper the premium. Also, the longer the option period, the higher the premium. So the illustration there again is under the swap term of 5 years, you're looking at a 2% swap strike rate, but now the option term is 1 year--1 year forward, so 12 months--for you to buy that option is $17,400. The higher the strike, the lower the premium. So as you can see, if you're willing to buy an option whereby the swap rate of the underlying 5-year is struck at 2.50%, you have the option period of 1 year, and the premium is $10,100.

So you can do a swaption based on a 5-year period or a 7-year period. And the grid to the right, where it says the swap term being 7 years, you've got the swap strike rate at 2% with a 6-month forward, the premium being $15,100. As you can see, as you move out of the 5-year term and give yourself a longer swap term, longer duration, that premium cost is slightly higher. You move the strike or the swap rate to 2.50%, that 6-month swap option becomes $7,100. And then again, moving it to a 1-year forward at 2%, it's $22,000. And then at 2.5%, 7-year strike rate for a 1-year term is $12,300.

And so that's basically giving you a flavor of how the option premium is calculated. The closer you are to the forward or the spot rate, the more expensive it is. The more term you want to purchase from an optionality, it's going to cost you a little bit more in the premium.

But again, Robert mentioned the flatness of the yield curve. It's very attractive currently for you to take a look at any sort of forward funding, forward commitment. If you know it's a known amount or an obligation, whether it's a bond renewal or a new funding, a term loan coming due, those forward swap rates are currently attractive because the term premium as you would see in a steeper curve environment is not there at the moment.

So we've studied, or we've discussed swaps, forward-starting swaps, and then options on those swaps. Now let's take a look at how we set these strategies. In executing a hedge strategy, it's important to factor in the current interest rate environment, and it's one that's attractive, although net-net since the end of last year, we've seen a dramatic increase and pop in rates. They should be factored in, in the sense that as rates rise, all of that gets baked into the yield curve. So based on your expectation and having a pulse on the economy based on your company's performance, you can judge and estimate whether actual interest rates will rise faster or slower than what the market is expecting.

Next, it's important to think about the company's business. What are your objectives? Is it to manage cash flows or financial metrics? And what are the accounting impacts? Other things to consider. Is your company highly leveraged? Is it cyclical? Does your company have the ability to pass through higher costs to your customers? These considerations should play a part when executing your risk management strategies.

We often get questions from our borrowers and clients, what's the right mix to manage your cost of capital? Is it more fixed or more floating-rate debt? And here are some thoughts.

For leveraged companies, as leverage increases there's a greater impact to your company because faster the rates rise, the greater the interest expense. As such, highly leveraged companies should have a greater fixed-rate mix. But again, you have to consider other factors and implications.

Cyclical companies. Cyclical cash flows often act as a natural hedge against debt, and companies that fit into this profile tend to have a higher floating-rate debt mix.

Industry risks. Companies with the ability to pass on increases in costs to their customers are better able to maintain a higher floating-rate mix debt.

So the shape of the yield curve is meaningful. In addition to the absolute level of rates, it can affect the preferred mix of floating- and fixed-rate mix. Historically, low long-term rates mean a greater fixed percentage. We currently have seen this with companies who have been able to save because net interest rates have been so low, especially those that have been weighted towards floating-rate debt. As rates declined, they had greater cash build. With that, some of the forward strategies have come into play as companies know that a combination of interest rates rising and normal CapEx needs, that they anticipate that debt issuance being needed in the 2- to 3-year time horizon. And we've looked at forward swaps as far forward as 2 to 3 years.

So some of the other considerations are highlighted here. It's unique to each company and the industry that you're in. But please do take a look at working with a PNC relationship manager and advisers on how you can best strategize to put on hedges.

A hedge policy with a target range rather than a set fixed target percentage of fixed and floating mix is a sound one. It's a sound policy. And knowing the tools that are available to achieve this is important, and we covered some of these today: the swap fixed rate in addition to the forward-starting swap rates and swaptions when there are uncertainties in the future about your funding needs and when the commitment will occur. I briefly mentioned the interest rate cap. It's another popular product that our companies use to hedge their risk management floating-rate debt.

So the factors we reviewed should play a big role in how you're going to mitigate risk in a rising interest rate environment. As you prepare for rising interest rates, we're here to help you along the way. Please do not hesitate to reach out to us either directly or through your relationship managers.

And with that, I'll turn it back over to you, Jim, for our Q&A, and I'll leave time for us to answer our clients' top-of-mind questions or needs.

James Bernier:

Terrific, and thanks, Tina, and thanks, Robert and Todd as well. Great discussion. Why don't we go ahead and transition to our Q&A period here. Just as a reminder, you can ask questions using the Q&A window located at the top left of your screen. So let's take a look at some of the questions. Lots of questions about Ukraine. Todd, I know this is an emerging development and it's very early and you haven't had a lot of time to process this, but can you maybe summarize thoughts on the Ukraine situation so far and maybe some impacts to the market?

Todd English:

Yes. So again, just to recap some of the thoughts here, the immediate thought is probably not materially impactful to the United States. Again, Russia's economy is something like 7% the size of the US's, so even with 100% sanctions on Russia, it's not going to have a direct impact on the United States. Where there's bigger risks are increased commodity prices and energy prices into western Europe. That will slow their purchasing ability for US exports. And there's a good chance that that probably will have an impact on the United States.

Our economies--that is, the EU and the US--are actually roughly about the same, and US exports to the EU make up about 1% of our GDP. So that does have the potential to be fairly substantial. I think when we look out further, again, it's additive to the inflation story when commodity prices rise into Europe. So we're really going to have to look for some other signs such as lower consumer confidence and lower purchasing. If that were to happen and the Fed is still in a rate-hiking cycle, that's when we really run the risk of substantially slowing growth. Hopefully, the Fed will be able to adjust on the fly as situations like that come up. But that's really where we see things happening, both in the short term and the long term.

James Bernier:

Yes, I think that makes sense, Todd. And I guess maybe another thing that's implicit in your response is that this current situation doesn't escalate into something much larger, which of course is a political and not an economic question. So let's keep our fingers crossed there.

Okay, maybe one for Robert. "My company is looking at foreign acquisitions. Are there strategies/products to hedge against a rise in my cost of capital in foreign currencies?"

Robert Leonard:

Yes, these products are not confined to just US dollars. Many of our clients are looking for acquisitions, obviously, in Europe and other countries. Interest rate derivatives, the swaps and forward-starting swaps, PNC can provide those in all the major currencies as well as the bank could also help you with the foreign exchange risk on those transactions as well. But certainly these products are not just confined to US dollars.

James Bernier:

Got it. I'm sorry, go ahead.

Robert Leonard:

Go ahead, Jim, sorry.

James Bernier:

Okay, there was another question that came through, just a quick one. "Can you use SOFR for swaptions?" Yes, absolutely you can use SOFR for swaptions.

Let's tee up another one for Todd. "It feels like there are a lot of hikes already priced in. Has the Fed historically raised rates anywhere close to this anticipated base?"

Todd English:

Yes, so this is a good question. Obviously, the Fed hasn't gone through a hike schedule anywhere near this aggressive in really almost two decades. We had substantial hikes back in 2004, again in '93. And then you have to go back pretty much all the way back to '87 before we see hike programs along the lines of what we're doing.

The one back in '87, and I know that's really a lifetime ago when we think about the world we live in today, but what we feel is somewhat meaningful about that '87 hike program that the Fed undertook was inflation was running nearly as aggressively as it is now. It wasn't as high as it is now, but that's probably the last time that inflation was quite as steep as we're seeing things as we have here today. We saw a little bit of that back in 2008 and 2009. It was a very steep slope on CPI. But it was also a very quick dip down that we had had previous to that.

So yes, and again, we do feel that the markets can sustain that, that the economies can sustain the hike schedule decently well and be able to absorb it. We do have a lot of bench strength as far as labor that's sitting on the sidelines that could be pulled back into the starting lineup if we needed to. And those are the type of things that are probably likely to happen. If the Fed really does start to raise rates aggressively, folks that are able to currently sit at home and help take care of their home, take care of their family, maybe incentive to rethink that, particularly if wages continue to rise at the same level that they're raising. Jim?

James Bernier:

Yes, I think it makes sense. Thanks, Todd. Tina, I think you may have touched on this one, but let's go ahead and put it out there. "Given the evolving interest rate market environment, our management team is evaluating our mix of fixed and floating rate debt. What are some targets that we should consider based on our business, and how have these targets changed with other companies you work with?"

Tina Hwang:

Yes, so it's not as simple to say, "Yes, target, a range of 50% to 65% fixed if your company is cyclical." I would actually flip that and say you should be 65% floating. So the debt mix is a target in the sense that some of the economic factors and the rate movement as it changes has had a big factor in the way our companies that we work with have been left with cash and fixed-rate debt. And some of the fixed-rate debt, if you combine it against the cash that they've got on and the fixed-rate debt, amounts to actually a negative carry.

But it is because of the dramatic interest rate cycle that we've come to know here with the zero rate environment that we're just coming out of. So it's depending on your company, set based on the mix of--the characteristics that your company has. And also factor in what the next 12 to 24 months of--if you're acquisitive, you want to factor that in. If you're divesting assets, you want to factor that in. But a target is really the greater goal of where you want your fixed and floating debt mix to be.

James Bernier:

Makes sense. I think sometimes it's hard to generalize too much here. Of course, we'd be happy to discuss any particular situation individually with your banker, and we'd be happy to participate in that as well. Thanks, Tina.

 I think we have maybe time just for one more question. Todd, this is for you. It's a tricky one and one that I know the Fed is trying to answer, too. The question is, "The interest rate hikes are in an effort to fight inflation, but will it slow our economic growth?"

Todd English:

Yes, that is a tricky one. Again, we've really been focused on the demand side of the equation here on the rate desk. Demand is incredibly strong, and there is definitely a path for the Fed to take to be able to continue to raise rates in a very slow and methodical process without materially dinging the demand side. And that's really how we keep the economy strong, how we keep the economy growing, is to not shock the consumer side of our economy. So yes, that will help alleviate some of the price pressures as we start to raise rates here. But again, that's why we're not really onboard with any of the March 50 calls that have been out there. Doing so is likely to scare away the consumer, and that's really what the Fed really doesn't want to see here. Again, they want to keep this expansion going for as long as they can.

James Bernier:

Yes, I think that's the art of being a central banker. Can you raise rates just enough to curb inflation but not so much that it slows growth. That's a real challenge, and I guess we're going to see how that plays out for the next several months.

I think we're pretty much out of time and would really like to thank Todd, Robert, and Tina for a great presentation today. And I know emerging situations impacted preparation for this. Appreciate everybody adjusting for that. You all provided some really great insight and perspective. And I would also like to thank all of our clients and everybody for attending today.

A replay of this webinar will be available in the coming days. In the meantime, please reach out to your banker should you have any further questions. And this concludes our presentation today. Thanks again for joining us.