Interest rates to rise in 2022-but by how much?
2021 saw large rises in term interest rates
Over the last 12 months, the Eurozone 3-year term rate recorded its largest rise since 2007; US rates had its largest gain since 2005 and in the UK, the 3-year term rate recorded its biggest gain since 1999. Yet, neither the US Federal Reserve or the ECB raised official interest rates and the Bank of England waited until December to move. Even then, the UK Base Rate only went from 0.10% to 0.25%.
Term rates are the market’s best guess at a point in time for where a reference rate like SONIA or Euribor will average out at over the fixed term. Last year, the market constantly reassessed its expectation for the future path of interest rates, pulling term rates higher as it became increasingly clear, as we progressed through the year, that inflation was not a temporary phenomenon and that central banks would eventually need to tighten monetary policy.
What do higher term rates tell us about the expected path for SONIA and Euribor?
From the table above, we can see that 2-year UK term rates increased by 1.11% last year. Priced into this rate was not only the initial rate hike that was delivered in December but also at least additional three rate hikes to come over 2022. The market currently attaches a 70% probability that the first of these additional rate hikes will come as soon as the next Bank of England rate setting meeting on February 3rd.
Rises in Eurozone term rates have been more muted due to the ECB’s more dovish stance, which sets it apart from most central banks around the world. The 5-year EUR fixed rate closed the year at 0.01%- the market’s consensus view on Dec 31st being that Euribor was still likely to average close to zero over the next 5 years. In the chart below, we disaggregate this 0.01% 5-year fixed rate into its individual 20 quarterly interest periods (black curve) and this more granular view implies a view that Euribor will remain below 0% for the next 2 years and then peak below 0.50%. Similarly, we can see that the 5-year GBP fixed rate of 1.13% implies an expected path for SONIA (green curve) where SONIA peaks below 1.50% before falling away. In the US, the Fed Funds rate is currently forecasted to peak at 1.75%, well below the 2.5% recorded at the end of the last tightening cycle in 2018.
Despite the rises in term rates that have taken place over 2021, the interest rate curves in the US, UK and Eurozone all still forecast that variable interest rates will peak at levels well below the 2% level that these central banks are mandated to target. Given that the Fed has recently expressed concern that the current economic outlook is stronger, with higher inflation and a tighter labour market than at the beginning of the previous rate tightening cycle, it doesn’t make intuitive sense then why US rates would peak 0.75% lower this time around or why the market’s view remains that real interest rates (nominal rates adjusted for inflation) will remain negative.
Is history a good guide to the future?
The post Global Financial Crisis environment was marked by low inflation, low growth, fiscal austerity and loose monetary policy. Given that inflation is at multi-decade highs, economic activity has bounced back strongly (the US economy is already bigger than its pre-pandemic size) and governments loosened the purse strings over the past two years and rightly spent huge amounts to support citizens and businesses, there is good reason to question why monetary policy now needs to remain so accommodative.
Some influential commentators see a need for interest rates to move to much higher levels than currently priced in. Bill Dudley, who served as Chairman of the New York Federal Reserve from 2009 to 2018 sees US interest rates getting up towards 4%, well above the 1.75% peak currently baked into market based forward rate expectations for the US.
Some European central banks have started to tighten interest rates already
Some central banks are already started to take action. In Europe alone, Poland has increased its Base Rate from 0.10% to 2.25% since September and the Czech Republic has been even more aggressive, raising its Repo Rate from 0.25% to 3.75% in the second half of 2021.
There is an increasing risk that the ECB, Bank of England and the US Federal Reserve will be forced to tighten interest rates more aggressively than is currently priced into forward rates. At the minimum, a realistic expectation is a return to positive real interest rates. As central banks have an inflation target of 2%, this would see SONIA/ Euribor moving back above 2% and possibly 3% over time.
As we saw over 2021, while official rates haven’t moved, the cost to hedge is already increasing. It pays to be pro-active when managing interest rate risk. Unless inflation falls sharply in 2022, the path of least resistance in 2022 for both official interest rates that determine the cost of borrowing and term rates that determine the cost of hedging will be higher. For the first time in a long time, interest rate cost line is a risk item that needs to be actively managed. The team at Vuca Treasury has been managing interest rate risk for over 25 years.