Things have changed

By Kevin Holme, Managing Director, Capital Markets

A look at how businesses can manage currency and interest rate risk in response to the Fed’s action.

Bob Dylan won the Nobel Prize in Literature this year, and his classic 1999 tune (which is the title for this article) with its opening line, “a worried man with a worried mind”, characterizes those of us trying to fathom the direction of rates, particularly in the wake of the November election and on the eve of the new administration.

Rates have spiked since November 9, 2016 – beyond levels not seen since 2015. However, this isn’t a surprise given assumptions about the new administration’s agenda of tax cuts, fiscal stimulus and less regulation to stimulate stronger economic growth. It’s worth remembering that rates were already inching up ahead of the election as a result of better economic reports and hints of increased inflation. Today’s unanimous decision by the Federal Reserve (Fed) to raise the Federal funds rate – the overnight lending rate between banks – to a range of 0.5 percent to 0.75 percent was more a reflection of the recent economic data as opposed to results stemming from the recent election. If anything, the Fed’s move simply validated what the market had already baked in to its forecasts. As we predicted back in December 2015, and again this past September, the Fed has, and will, continue to proceed cautiously – measured in its response and data dependent – as it tries to normalize monetary policy after years of easing.

So, let’s address concerns about higher rates in 2017 and beyond. The most frequent question we hear is “I missed the big move in interest rates, what should I do now?" First of all, as the Brits would say, “Stay calm and carry on.” The current expansion has been very weak by historical standards (averaging just 2.1 percent annually, according to the U.S. Bureau of Labor Statistics) leading to lower interest rates for longer than expected. There are many reasons for this slow economic growth, including high household debt levels, reduced credit availability and tighter regulations. Recall also from textbook economics that over the long run, economic growth is a function of labor force productivity and demographics. Neither is as robust as they were in the '80s and '90s. So while Trump tax cuts and infrastructure spending may give a one-time boost to the economy, it’s unclear if this will be sustainable over time. Finally, and most critically, current rates are still exceptionally low by any historical measure.

Here are three quick and actionable ideas for those who didn't hedge and are pondering alternatives:

1. Hedge 50 percent now and 50 percent later next year. At a minimum, get some protection. The future is unknown and the past is past. Market events are beyond our control and not to decide, is in fact, to decide.

2. Buy an interest rate cap/ceiling now that provides “catastrophic coverage” against a major move up in rates. You can always replace the cap with a swap sometime next year if rates fall back. In the meantime, this is protection from a major rate shock due to monetary or fiscal moves, or if growth is actually stronger than expected. Discuss with your relationship banker alternatives that provide real value across different levels of risk protection.

3. Create a swap that is cancelable without penalty after just 12 months. This strategy works well in the current environment – it creates certainty without regret. If the current spike in rates is overdone, then next year you can cancel the swap in place and re-swap at lower rates. We like this alternative best because it provides both flexibility and multi-year protection at a reasonable price.

Bottom Line

  • As expected, the Fed raised rates by 25 bps today, and it’s safe to assume there will be further rate increases in the future. While we don’t expect the Fed to deviate from a measured approach, never-ending central bank support for the market is unlikely as the new administration gets rolling. The Fed indicated it will likely be raising rates next year by another 0.75 basis points; with the future increases most likely occurring in three one-quarter point moves.
  • Expect more volatility and uncertainty – your relationship banker can help you prepare for the unknown and preserve future flexibility.
  • Despite recent rate increases, market conditions today still offer borrowers well-priced hedging tools to both control interest expense and preserve flexibility.

We’ll close with some last lines from Mr. Dylan,

People are crazy and times are strange
I’m locked in tight, I’m out of range
I used to care, but things have changed

Yes – crazy, strange and change sum up a lot of things this year. That said, your relationship banker can help make sure you’re not “locked in too tight or out of range.” For further discussions on how MB can help your business navigate the rate environment going forward, contact your relationship banker or us directly...then put this tune on and play it loud!