Where is inflation going?
US inflation hit 8.5% in March and is now at its highest level in 40 years. Supply chain issues related to COVID-19, combined with the Russian-Ukrainian war, have driven energy prices up 32% over the past few years. report. And food prices follow, up 8.8% – the biggest jump since 1981. Consumers everywhere are feeling the pressure, and many analysts predict a US recession.
With good reason, the US Federal Reserve is worried.
To curb inflation, the Fed began an upward cycle at the FOMC meeting last March, raising the federal funds rate by 25 basis points (bps). And it has just delivered what the market expected at the last meeting on May 5: a rate hike of 50 bps. This is more aggressive than the first hike and shows how alarmed the central bank is at the changing inflation outlook.
But what comes next? The market speculates wildly. Questions abound about the intensity of further rate hikes and whether the economy can sustain half a dozen hikes this year without slipping into recession. On the other side of the coin, fears of runaway inflation underscore the danger of being caught behind the curve. For inflation hawks, catching up via aggressive rate hikes is an absolute necessity.
CPI inflation and job creation
Fed decisions will significantly affect the outlook for businesses and investors. So how can we cover this uncertainty?
In a context of galloping inflation and rising interest rates, financial risk management is essential. We need to protect ourselves from interest rate volatility, anticipated and unexpected increases. But how? And given how quickly short-term rates have skyrocketed, is it too late to cover our floating debt? How can we prioritize financial risk management objectives?
Don’t be obsessed with market developments
Interpreting the Fed’s tone regarding potential rate hikes should not be the primary focus. Instead, we need to look closer to home – our business risk profile. The higher the leverage on the balance sheet, the harder it will be to absorb rate hikes and shocks. Yet good risk management provides both proactive and reactive measures to cover these market risks.
Since January 2012, the Fed has published its interest rate expectations every quarter. The so-called Dot Plot shows the Fed’s expectations for the short-term key interest rate it controls for the next three years and for the long term. The dots show each Fed member’s anonymous vote on the expected rate move.
While these only guide Fed actions, some companies mistakenly rely on them to inform their risk management and hedging decisions. Yet waves of crises and unexpected events frequently thwart plots and often prove them wrong: in March 2021, for example, most Fed members were expecting zero rate hikes in 2022 and 2023!
Just one year later, the March 2022 Dot Plot showed a massive shift in Fed expectations: from the March 2021 forecast of zero rate hikes in 2022 to the March 2022 forecast of six rate hikes in 2022. And since then, the tone of the Fed has only grown. falcon. We shouldn’t focus on what the Fed says it will do; it most likely won’t.
Understand your debt exposure and its sensitivity to interest rate fluctuations
All businesses should carefully plan for their current and future debt needs. Financial risk management becomes easier with a clear debt plan.
But whether financing an acquisition, refinancing a loan or supporting ambitious investments, the hedging strategy requires the utmost attention. After all, if the pandemic has taught us anything, it’s that the future is radically uncertain.
As part of the hedge evaluation and feasibility process, a company should establish reasonable expectations for the term, amortization schedule, and floating interest rate index and assess the tools available to implement its planned hedging strategy.
With coverage products, go old school!
The choice of hedging instrument requires careful consideration and thoughtful consideration in order to reduce and mitigate market risk arising from interest rate exposure. We can reduce the risk by creating an offsetting position to counter the volatilities shown in the fair value and cash flows of the hedged item. This may mean giving up some gains to mitigate this risk.
It is always advisable to stick to vanilla instruments to cover our debt. These include interest rate swaps and interest rate caps. Future debt can also be covered with fair anticipated debt insurance. A delayed start interest rate swap (simply booking a fixed swap rate into the future), an interest rate cap and other simple hedging instruments can achieve this.
The more complex a hedging instrument becomes, the more challenges it introduces to price transparency, valuation considerations, hedge accounting validity, and overall effectiveness. So we should keep it as simple as possible.
It is impossible to time the market
“Time the market is a fool’s game, while time spent in the market will be your greatest natural advantage. -Nick Murray
The previous statement applies to risk management. Companies should avoid trying to find the best entry point for coverage. Instead, we should act according to predefined objectives, risk tolerance, hedging parameters and a governance framework.
Consider the current interest rate environment. In companies sensitive to higher interest rates, management may believe that rate increases are already reflected or priced into current market levels. Management may not believe that the yield curve will be more expensive in the future and may think there is no need to buy hedging.
However, there are hedging products that offer more flexibility in low rate environments while providing protection on the upside. A hedging policy governs all of these factors in more detail and provides management with the necessary guidance to avoid relying on subjective, individual decisions.
Why is hedge accounting important?
When using hedging instruments to protect the business from adverse market movements, the accounting implications are critical.
Proper application of hedge accounting standards reduces financial statement volatility in corporate accounting. Hedge accounting makes it possible to reduce the volatility of the income statement (P&L) created by the repeated adjustment of the fair value of a hedging instrument (mark-to-market – MTM). The critical terms of the hedged item (debt) and its associated hedging instrument (financial derivatives) must match.
Hedge accounting follows a well-defined accounting standard that must be applied for successful designation. Otherwise, the fair value of the hedging instrument would directly impact the income statement. Some institutions prioritize accounting implications over economic benefits and vice versa. The hedging policy should address what comes first in terms of prioritization.
Take away food
In uncertain times like these, there are countless perspectives on the direction of future market movements. The inflation hawks are becoming more hawkish, while the doves remain firm in their bearish stance.
Businesses and investors reap the benefits of a good financial risk management plan during good times and bad. Such preparation mitigates the effects of our personal cognitive biases and ensures durability and endurance in the toughest market conditions.
While we can’t and shouldn’t cover everything, sound planning cultivates a culture of risk management across the business. Ultimately, however, the board and management team are responsible for setting the tone.
Again, Nick Murray offers some wisdom:
“All financial success comes from acting on a plan. Much financial failure comes from reacting to the market.”
Warning: Please note that the content of this site should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of CFA Institute.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.