Interest rate hikes are on the way: here’s how to make your business ready
As the world economy moves out of the shadows of the financial crisis and austerity, we are also saying farewell to a period of low interest rates.
The US has already taken advantage of a stronger economy to make the move and the European Central Bank is expected to follow suit next year. So now is the time for businesses to look at the management of interest rate risk as the move towards a more normalised monetary policy regime continues.
The US Federal Reserve announced a tapering of asset purchases and officially ended quantitative easing in October 2014, preparing the way for the first official rate increase in December 2015. The Fed’s funds rate now stands at 2.25pc with projections that the rate will continue to rise and plateau just above 3pc.
“The US Fed led the other major Central Banks from the outset,” said Ciaran Cash from the Corporate Treasury Risk Solutions division at Bank of Ireland Global Markets.
“It was the first to reduce rates when the global financial crisis hit in 2008, lowering rates from 5pc to 0.25pc within a 15-month period.”
Despite the fact that the US Federal Reserve has now raised interest rates 8 times, the jury is still out on when the ECB will follow suit. Some investors believe that outgoing bank President Mario Draghi will leave before there’s a rate hike in the Eurozone while others say a hike will be one of his last legacies before he steps down at the end of October of next year.
The ECB has a lot to consider.
While core Eurozone inflation has been subdued, inflationary forces are gradually building toward the ECB’s 2% target.
There are other reasons why there is reticence and there are other storm clouds gathering: Eurozone activity has softened in the beginning of 2018, the Potential Brexit impact, while there are growing global trade tensions and uncertainty in the Italian economy.
“How the Eurozone economy navigates these issues and continues to grow will determine the actual pace and extent to which the ECB will need to raise interest rates to fulfil their mandate of price stability,” said Cash.
Still, recent German inflation rates of 2.3pc year-on-year have surprised some and the Euribor forward curve currently suggests a rate increase towards the end of 2019 with rates continuing higher at a gradual pace of about 1pc over the following five years.
This year marks the tenth anniversary of the global financial crisis and no one wants a return to those days.
One weapon in a central bank’s armoury if the economic climate was to turn negatively again is the ability to cut interest rates in a bid to kick-start an economy, but this can’t happen if they remain at historic lows.
“It’s recognised that while rates remain at 0.00pc, there is no buffer for the ECB to adjust interest rates lower to offset any new economic downturn. So while achieving its primary mandate of price stability is paramount, the ECB will want to return interest rates to a more normal level at the earliest opportunity,” Cash added.
He said that for corporate or large business borrowers current paying interest rates at a variable Euribor rate; this is a timely opportunity to undertake a review of your company’s exposure to rising interest rates. It is worth considering that the rate at which it is possible to hedge currently is anticipated to be higher by the time the ECB does begin to tighten.
“For example, for a corporate or large business borrowing €10m over a five-year term, every 0.01pc increase in the forward curve has a present value impact of about €5,000 on our projected interest bill over the term of the loan. To put this in context, in the past six weeks the five-year rate has increased by 20 basis points,” Cash said.
Cash added that a more normal rate of interest for the Eurozone, i.e. where the ECB is neither tightening nor loosening monetary policy, is estimated around 2pc but how quickly we get to that level depends on the outlook for growth and most importantly inflation within the Eurozone.
“At present the forward curve does not anticipate three-month Euribor will reach 2pc until January 2029.
“But by using fixed rate hedging products today, you can secure your future interest bill, at this current benign outlook for euro interest rates. Of course the actual path of interest rates could still undershoot these expectations but by hedging you are protected by a fixed rate if the opposite occurs,” he said.
A moderate interest rate increase, at least, looks inevitable in the near future and might be a very sensible move, especially if we are to learn from the mistakes of the past.
And planning for that looks equally sensible.
Current market expectations provide for a first ECB rate increase toward the end of 2019 with official rates to rise at a gradual pace thereafter to 1.00% in five years. Of course, the actual path of interest rates will be determined by the ECB, based on actual future economic conditions and the inflation outlook in the Eurozone.
This creates uncertainty which companies can address by putting in place appropriate interest rate hedging today. This will protect your business against interest rates rising in the future at a faster pace than currently anticipated.
Bank of Ireland Global Markets can quantify your exposure to every 0.01% rise in rates. For a range of solutions for managing interest rate risk in a rising rate environment, please click here.