Strategizing around Volatile Interest Rates

On Dec. 14, 2022, the Federal Open Market Committee (a committee within the Federal Reserve System) raised its target rate +50 basis points, making the new upper limit of the Fed Funds Rate to set at 4.5%. While the actual change in the target rate came in as expected, the still very hawkish stance from the Fed may have surprised some market participants due to the recent inflation data that has shown some improvement. 

Fed Chairman Jerome Powell maintained a consistent message and continues to prioritize price stability over economic growth, stating rates should stay restrictive for “some time.” Prior to the meeting, the market expected a terminal Fed Funds rate of 5%, with rate cuts commencing mid-2023. 

After the meeting, we are now expecting a median end of year 2023 Fed Funds Target Rate of 5.10%, according to the latest publication of the FOMC dot plot, which suggests we could see another +75-basis-point increase from here. It’s worth noting that the expected terminal rate as of June 30, 2022, was only 3.5%. This illustrates just how quickly the interest rate landscape can change, and everyone is still trying to find a crystal ball that works. Did anyone think we would see +425-basis-point increase in the target Fed Funds Rate at the beginning of this year?

The interest rate environment continues to be choppy, and financial institutions and commercial customers alike are strategizing on how best to navigate around increased volatility. Planning for future rate hikes or cuts can be challenging and outlooks are often revised throughout the year; however, not having a forecast makes it difficult to plan around a dynamic interest rate environment. In times of increased volatility, it is important to partner with a financial institution that is equipped with the tools and subject matter experts that remain creative and innovative to find appropriate solutions for customers’ needs.

Using interest rate swaps and other derivatives on commercial loans and LOC can help add certainty and peace of mind when interest rates are on the move. Vanilla interest rate swaps offer all the benefits of a conventional fixed rate loan, with the additional advantages of fully customizing the hedge based on the customer’s own outlook for interest rates. Will future rates exceed the current forecast? Will the Fed go too far and resort in cutting rates aggressively to pull the U.S. out of a recession? Will rates stay elevated much longer than anticipated? These are just some of the common questions being asked today. Using an interest rate cap, collar, partial hedge or any combination can help address these questions, all while giving commercial customers the ability to create a risk management strategy that is appropriate for their business.

Finally, proper planning on the front end of any new credit request is important, but incorporating options that allow for expanding, de-levering (prepayments) or organization changes can sometimes be overlooked. Interest rate hedges are fully customizable and are built to consider business life-cycle changes that may occur during the credit facility’s term. For example, entering into a long-term loan at the onset may make sense; however, capturing the ability to exit along the way without any prepayment penalty may add value based on historical repayment behavior. Or, executing a partial interest rate swap on a percentage of the outstanding debt will deliver a blended interest rate between floating and fixed rates of interest, and allow for prepayments and the ability to participate in the event floating interest rates fall during the loan term. 

Regardless of the direction of rates and the velocity in which they move, implementing a prudent hedging strategy can add value for both commercial customers and the lending institution.  

Ryan Frette is WaFd Bank’s interest rate derivatives manager, specializing in interest rate sales and trading. Frette has helped banking customers with hedging strategies and deal structuring for nearly 20 years and is actively involved in various capital market functions within the bank.