ECB to close out 2022 with a final rate hike
One more rate hike from the ECB this Thursday
All three major central banks meet this week and will raise official interest rates again. Rate hikes of 0.50% are expected in the US tomorrow evening to take the US Fed Funds rate to 4.5% and on Thursday in the UK to take the Bank of England Base Rate to 3.5%. A 0.50% rate hike bringing the ECB depo rate up to 2.0% is the most likely outcome following Thursday’s ECB meeting but hawkish comments from ECB officials mean that a third consecutive hike of 0.75% cannot be discounted. The market is attaching a 30% probability to this outcome.
But the cost to hedge has fallen in recent weeks
Although benchmark interest rates have been rising rapidly since the summer, term interest rates and the cost to hedge have been actually been falling since the end of September. In the Eurozone, 3-year swap rates have fallen from 3% to 2.73% and the cost of a 3% 3-year Cap on €10m has dropped by over €0.1m. In the UK, the fall has been even more dramatic due to the sell-off in gilts and initial spike in UK term rates wreaked by the Truss/ Kwarteng mini-budget. 3-year swap rates in the UK have fallen from 5.77% to 4.12% and the premium on a £10m 4% Cap has dropped by £0.3m.
Hedging can raise debt capacity as well as manage cash-flow
The reduction in volatility and recent drop in the cost to hedge have been welcome. Interest rate risk had been dormant for over a decade but over 2022 has become a key strategic concern. Many lenders are stress-testing new applications at a c2% premium to the contemporaneous forward curve which has resulted in a material decline in credit appetite and debt capacity. Borrowers normally hedge to mitigate the potential of a breach in interest cover covenants on drawn facilities but increasingly, we are also working with clients to structure interest rate hedges, especially Caps, to allow clients increase the debt capacity in new loan applications or to manage the market risk on refis in 2023.
Rates outlook is more balanced for 2023
With one policy meeting to go in 2022, both the US Federal Reserve and Bank of England are on course to deliver their most aggressive tightening cycle in over 40 years. For the European Central Bank, only formed in 1998, 2022’s tightening cycle is already at a record high. Central banks are still expected to raise interest rates in the New Year so we can expect an even tighter rates environment in H1, 2023. However, the pace of adjustment should be more sedate as central banks will most likely want to understand what impact the hikes in 2022 have had on economic performance.
A return to policy changes of 0.25% clips should manifest itself in a less volatile rates environment too. However, until it’s clear that inflation is heading at least towards the level of official interest rates (let alone the lower 2% inflation target), the bias is going to be for rates to remain higher for longer. The risk of a higher rates environment at the end of 2023 cannot be discounted, even if the recent move lower in term rates suggests otherwise.
For more information on how Vuca Treasury can help you evaluate and manage your interest rate and currency risk, please contact the team by mailing hedging@vucatreasury.com
Martin Mulligan
Managing Partner