Monthly Rates Update- Rising Interest Rates

Transitory inflation

Base effects from Q1/Q2 have faded but inflation is still accelerating around the world. US CPI for September was released yesterday and came in at 5.4%, its highest level since 2007. The BOE expects UK inflation to be above 4% at the end of the year and inflation in Europe is running hot at 3.4%-when Eurozone inflation was last at this level, the ECB’s benchmark refi rate was +1.5%…positive Euro interest rates, what a quaint concept that seems now! In a sign that global inflationary pressures aren’t going to disappear anytime soon, Chinese September factory gate inflation rose 10.7%y/y- a record high since the National Bureau of Statistics started compiling the number in 1996.

Market rates adjusting higher

In response, the rates markets have started to price in higher interest rates. This is most evident in the UK where 2-yr GBP Libor rates rose by 0.24% over September and already by a further 0.20% in the first 2 weeks of October. As recently as the end of August, the forward curve for SONIA was pricing in no rate changes for the UK in 2022. The market now has 3 rate hikes fully priced in for next year, with the first to take place in February. There is even a 30% probability that a first rate hike could arrive as soon as November.

Difficult choices for UK borrowers

UK borrowers are faced with a dilemma-recognising the benefit of protecting themselves from a rise in finance costs when business costs are also rising but loathe to pay the cost of carry- moving from a variable rate of 0.10% to a fixed rate over 0.80% higher. Caps look relatively attractive, combining protection with the ability from the lower variable rate should the forecast steep path for SONIA/ Base not materialise.

But hedging window still very much open for EUR counterparts

Unlike counterparts in the UK, where term rates have risen by 0.65%-0.80% this year, Euro term rates have been slower to adjust higher due to the ECB’s more dovish stance. The expected cost of servicing a 3yr £10m loan has risen by almost £280k this year while the expected cost of a EUR loan has risen by only €70k (see chart above) For EUR borrowers, while swap rates have returned to pre-COVID levels, there is still plenty of value available in both Swaps and Caps. The forward curve still has negative Euribor rates priced in until April 2025, so unlike GBP borrowers, it is still possible to secure cheap term funding close to zero. However, the UK experience should be a salutary lesson for EUR borrowers still sitting on their hands. GBP 3-year swap rates were negative at the start of 2021 as the BOE toyed with the idea of introducing negative interest rates, 10 months later there is a material risk the Bank of England will start a tightening cycle before the year is out. The maxim that it’s better to fix the roof while the sun is shining still rings true.

Time to act

As we’ve been counselling for some months now, with business costs rising, borrowers should take the time to review their hedge positions to ensure their finance costs are controlled. Please feel free to contact the Vuca Treasury team at info@vucatreasury.com for more information about how best to manage your financial risks. Or find out more about hedging products like interest rate swaps and interest rate caps at these links.