Sonia Foward Curve Forecast 2023
Forward curves are often useful for forecasting floating-rate debt. These forward curves are used to price SONIA and EURIBOR based derivatives including swaps and interest rate caps. The forward curve represents the market’s current expectations or prediction for future interest rates (live pricing on Bloomberg and Refinitiv platforms). Given the unpredictable nature of energy prices, global recession risk, geopolitical risks, etc accurately predicting the forward curve can be difficult.
The two main factors driving the direction of interest rates and the cost of hedging in the UK market over the past three months have been the aggressive tightening cycle pursued by the Bank of England since the end of July (0.50% interest rate hikes in August and September followed by a 0.75% hike earlier this month) and the disastrous mini-budget announced by then Chancellor Kwarteng on the 23rd of September which led to a major sell-off in the UK gilts market/ rise in term rates and ultimately the collapse of the Truss premiership.
Current SONIA Rate
As per the chart above, 3-year swap rates were trading sideways over June and July until it became evident that the Bank of England would increase the pace of its monetary policy tightening from the standard adjustment of 0.25%. The shift to larger 0.50% & 0.75% adjustments saw 3-year term rates rise from 2.33% at the end of July to 3.96% by mid-September.
The 3-year swap rate then spiked to 5.61% in the days following the mini-budget on the 27th, before the Bank of England successfully intervened to calm UK markets. The 3-year rate closed on the 30th of November at 4.08%, which is the lowest level it has traded at since before the mini-budget debacle.
Implied volatility, a major component of Cap pricing has also fallen sharply as stability has returned to trading conditions. The combination of a levelling in the SONIA forward curve and a lower risk premium for the UK has resulted in lower hedging costs for borrowers over the past 2 months. The cost per £10m to cap SONIA at 4% for 3 years is now £264k, less than half the £563k per £10m it would have cost to buy a Cap on the 27th of September. Reduced cost and stable trading conditions make this an attractive time to consider hedging interest rate risk on SONIA debt.
Sonia vs Base Rate
The UK Base Rate is currently at 3%. The Bank of England’s monetary policy committee meet next on the 15th of December and the market has almost fully priced in a 0.50% rate hike, to take the Base Rate up to 3.5%. A further 1.0% in rate increases from the Bank of England are fully priced in by financial markets across the first 3 meetings of 2023.
Sonia Forward Curve
The market is now forecasting that SONIA will peak just above 4.50% in the middle of 2023 before reverting to the 3.50%-3.60% level compounded SONIA is expected to average at over the next 3 months. The inverted curve is also helping to bring down the cost of hedging as Caps at higher strikes, say 4%, are “out of the money” at the back-end of the 3-year term. Normally, most of the cost of a Cap is incurred towards the back end of the hedging period so the inversion in SONIA forward rates is a welcome development
Check your financial covenants
Borrowers should consider the impact of rising debt service costs on their financial covenants. When hedging, most borrowers look to/ are required to hedge their debt to minimise the risk of a breach of the interest cover covenants. Rising interest rates will have an immediate impact on any covenants which are focused on monitoring the ability to service debt costs such as debt service/interest cover. A breach of your debt covenants may lead to a response from the bank which may include accelerating the repayment of the loan
· Stability has returned to UK markets in recent weeks reducing the cost to hedge
· Pricing now for Caps are at their best levels since the middle of September