Should I Stay or Should I Go?

By Kevin Holme, Managing Director, Capital Markets, David Rubin, Senior Managing Director, Capital Markets

Analysis of the Fed interest rate hike

We occasionally ponder what working at the Fed is like, particularly on days when the central bank decides it’s going to act on interest rates. Like today, for instance, as outgoing Chair Janet Yellen got her last official time at bat. As we imagined what was going through her mind today we were reminded of an old favorite, going back to the golden age of punk music, by The Clash:

Should I stay or should I go now?...
If I go, there will be trouble
And if I stay it will be double

Well, as expected, the Fed did decide to go, and voted to raise the Federal Funds Target Rate by 25 basis points. And it's expected the Prime Rate will jump by 25 bps. Looking ahead into 2018, the market is expecting (with about a 70 percent probability) at least two hikes next year rather than the three bumps the Fed says it’s penciled in. The Fed has now raised rates five times since December 2015. Assuming two hikes in 2018, it will mean the Fed has increased rates a total of 175 basis points since the start of this particular tightening cycle.  By its own admission it is not done yet. And as the song says, it could still be double, with or without Chair Yellen.  

With the Fed raising short-term rates three times in 2017 it is no surprise that LIBOR has risen from under 1.00 percent in December 2016 to about 1.50 percent today. Perhaps more surprising is that the rate on the 10-year U.S. Treasury note sits at almost the same 2.40 percent level of December 2016. Admittedly, over the last 12 months the 10-year Treasury has ranged from as low as 2.00 percent to as high as 2.60 percent. But the fact remains that it’s basically unchanged from December 2016 to today at 2.40 percent. Why is that?

A number of factors explain the stickiness of long-term rates over the past year. For much of 2017, inflation (as measured by the Fed) has remained below the Fed’s stated annual targets of 2.00 percent. We don’t believe this low inflation is sustainable as domestic employment gains continue, and importantly, as global growth is now clearly visible on the horizon. With global growth, interest rates around the world are bound to increase, further spurred as the European and some Asian central banks begin unwinding years of QE-driven bond buying. When that happens, U.S. Treasuries may no longer be among the highest-yielding debt and note buyers will look elsewhere for higher yields. Fewer foreign buyers, as the Fed continues trimming its massive $4.5 trillion holdings of Treasuries and mortgage securities, will also serve to press rates higher. Finally, the Republican-sponsored tax cuts could boost the U.S. economy along with corporate earnings. Therefore, we think there are plenty of reasons long-term rates have an upward bias from their still historically low levels. 

Presently, with long-term rates still at historic lows and short-term rates continuing to edge higher, market conditions today still offer borrowers extremely well-priced hedging vehicles to control interest risk and expense and preserve great flexibility. We advise our clients to consider hedging alternatives that span beyond the normal fixed-rate swaps and loans. These include interest rate caps, collars and swaps that have embedded cancellation options in order to provide maximum flexibility, optionality and protection where the rate outlook continues to be uncertain. 

Bottom Line: 

  • As expected, the Fed raised rates by 25 bps today, and it’s safe to assume there will be further rate hikes coming. While we don’t expect the Fed to deviate from a measured approach, the U.S. central bank is no longer supporting the market as global growth expands. The Fed indicated it will likely be raising rates next year by another 0.75 basis points (three one-quarter point moves).  
  • Expect more volatility and uncertainty. 
  • Despite recent rate increases, market conditions today still offer borrowers well-priced hedging tools to both control interest expense and preserve flexibility. 

For further discussions on how MB can help your business navigate the rate environment going forward, contact your relationship banker or give us a call directly.