SONIA & EURIBOR can pivot quicker than borrowers can respond
- Central Banks in the US (Wednesday), UK and Europe (both Thursday) meet this week
- All are expected to leave their policy rates unchanged
- Hedge pricing has improved as markets are pricing in rate cuts for 2024
Central Bank statements and Financial Markets pricing continue to diverge
The US Fed, Bank of England and ECB meet this week and it’s widely expected that they will all leave their official interest rates unchanged, as happened at their most recent policy meetings in late October/ early November. We need to go back to July for the last time the US Fed raised rates (to 5.25-5.50%). For the Bank of England, it was in August (to 5.25%) and the ECB, September (Depo rate to 4.0%, Refi rate to 4.5%).
In the period since those last interest rate hikes, opinions at central banks and financial markets on the likely future path for interest rates have noticeably diverged. Central bankers remain cautious, warning that rates need to remain “higher for longer”, sticking to their mantra that more remains to be done to return inflation to the 2% target that all three economies are separately targeting.
Financial markets have become more dovish, anticipating that falling inflation will lead to lower interest rates. From levels above 10% this time last year, the most recent inflation print in the UK was 4.6% and in the Eurozone it was even lower at 2.4%. With most of the reversals in inflation occurring in the second half of the year, 2 year EUR fixed rates have dropped from 3.6% to 2.97% since September and UK 2 year rates have been tracking lower since July, dropping from a peak of 6.2% to a current level at 4.64%.
2024 rate cuts priced into all hedging products
A fixed rate is essentially a snapshot of the average rate the market expects for euribor or SONIA over a fixed period of time. Remembering this, the fact that the 2 year UK fixed rate (4.64%) is trading at a discount to SONIA (5.19%) and the 2 year EUR fixed rate (2.97%) is ~1.0% below 3 month euribor (3.95%) implies that financial markets have already priced in a number of rates cuts over the next 2 years. As the table below illustrates, financial markets are pricing in that central banks will front load rate cuts in 2024. Currently, 3 rate cuts in the Base Rate to 4.75% in the UK and a deeper 5 cuts to 2.75% in the Depo rate from the ECB in 2024 are implied by the forward curve. As the forward curve is the foundation upon which the pricing for all hedge products is derived, pricing for Swaps, Caps and Collars have all improved in recent months for GBP borrowers but especially for EUR borrowers where pricing is now at 2023 lows.
Low risk is not the same as no risk
Only time will tell whether it is central bankers or financial markets that have read the runes correctly. In our last commentary we spoke about how poorly the forward curve is at predicting the actual path that interest rates take, and this remains the case. The cuts priced into the forward curve can be quickly reversed if inflation picks back up again and borrowers should be mindful not to become complacent. The low level of risk that markets ascribe to the probability of higher rates from here is not the same as an absence of risk, and markets can pivot quicker than borrowers can respond. This is especially true for interest rate sensitive borrowers.
How divergent-and in what direction- the actual realised path for rates turn out to be from central bank or market expectations will only become apparent with the benefit of hindsight. Financial and hedging decisions are made with incomplete information. However, the deepening inversion in the forward curves in the UK and especially the Eurozone are throwing up some attractive opportunities for borrowers to lock in a series of rate cuts that may never actually arrive. Borrowers should take this improvement in pricing as an opportunity to ensure that the current level of hedging on existing or prospective debt is appropriate for their risk appetite and take steps to realign their hedging where this isn’t the case.
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