Where's the Rate Risk?

Published September 22, 2015  /  In The Fed 2015

Now that the Fed dodged a September rate hike, many observers are questioning whether a rate hike is on hold until next year.  This leads bank portfolio managers and commercial borrowers to ask “where’s the risk”.  After all the recent market volatility, LIBOR; Fed Funds; OIS; and even Prime are all unchanged.  So again, where’s the risk?
Well it’s out there, and as ever we can track the rate risk profile by looking at the forward swap curve.  Throughout 2014 and 2015 the swap curve has pushed back on Fed-speak to pour water on rate hike expectations, but, the swap market has priced in rate hikes in 2016.

The Swap Curve
At a glance, the swap curve is forecasting 3 month LIBOR to be at 0.90% (up 60bps) by the end of 2016 now.  By the end of 2017, 1.63% and by the end of 2018 2.04%.  Even these modest rate increases are likely to put pressure on long term rates and to lead to higher swap rates and bond market volatility.  Though a 60bp increase in a 3 month rate may seem modest, look at that move in context of a 10 Year treasury yielding 2.20% today!

But the swap curve isn’t the only forecast we should look at, the Fed releases its own forecasts every three months and last week we got an updated “Dot Plot” which continued to point to a far more aggressive tightening than that priced into the swap market. 

Details from the “Dot Plot”
13 of 17 Fed Governors see a 2015 rate hike.  The Fed projects a Fed Funds rate of 1.50% by the end of 2016, 2.50% by the end of 2017 and 3.50% by the end of 2018.  While these rate moves seem highly improbable in the context of the current “zero rate” world, they remain very, very low in context of rates in a “normal” economic environment.  The Fed is looking to manage unemployment, and inflation.  The Fed also wants to manage a return to normality.

Buy Low, Sell High
Inaction by the Fed has left a window open to portfolio managers to re-position their books for a future rate shift.  Strategies to consider include portfolio optimization to manage duration and re-position for rising rates.  Bond swaps open up possibilities to re-structure the portfolio in a tax efficient manner in the last quarter of 2015.  Swaps offer an alternative approach to managing the book.  Swaps and caps offer great value, especially given the disparity between the swap curve and Fed forecasts.  Hedge accounting options eliminate the risk of earnings volatility related to hedging strategies.
For borrowers rates are low, low, low and offer an opportunity to lock in capital costs for the long term.