The fat rise in long-term rates since August 2021 [1] has been of unprecedented proportions in Europe.

DanIn the Euro zone, the spectacular rise of the deposit facility rate, which has increased by 400 basis points since the fall 2021 [2], was coupled with a violent rise in the long-term rates until September 2022, followed by a certain stabilization of the 10-year rates at around 3%.

Since the Euro was created, the temporary periods of rates hike had only lasted for two to three years, and had been more limited in their magnitude

Since the Euro was created, the temporary periods of rates hike had only lasted for two to three years [3], and had been more limited in their magnitude.

In this context, borrowers express their fear of fixing rates at levels that are too high and seek to alleviate the hedging obligations by which they are bound, so as to postpone the decision to hedge the interest rate risk.

Is this a good idea? Does the economic and financial context allow to hope for a quick fall of long-term rates? Are there any alternatives to the wait-and-see strategy?

An unprecedented market environment

Depuis quelques mois, nous assistons au contraire à une remontée rapide des taux longs. Les emprunteurs ayant mis en place des pré-couvertures de taux s’en félicitent, et d’autres emprunteurs se posent désormais la question de la pertinence de ces stratégies de pré-couverture.

Dans quel cas les stratégies de pré-couverture sont-elles adaptées ? Est-ce que la hausse des taux récente traduit un changement de régime ou un simple réajustement des taux longs en sortie de pandémie ? Quels paramètres pour une stratégie de pré-couverture de taux ?

What does the recent rise in long term interest rates mean ?

1. The presistent inflation compelled the ECB to take action

The first ECB's key rate hike occurred in July 2022 when inflation in the Euro zone was already approaching 9% on an annual basis. But market rates had started increasing a year earlier, in mid-2021, as soon as inflation in the Euro zone exceeded 2%.

While the so-called "headline" [4] inflation has significantly reduced since October 2022, the "core" [5]  inflation has on the contrary not followed the same path. This is a major concern for the ECB as well as for other western central banks.

Those massive ECB rates hikes since July 2022 successfully convinced the markets that inflation would stay under control. As a result, the markets now expect headline inflation to fall back to around 2.5% by 2024.

The persistent inflation compelled the ECB to take action

ECB's forecasts also point in this direction, even though the ECB admits that inflation could remain above 2.8% over the next three years with a high probability of up to 40%.

Source : BCE-Eurosystème. Projections économiques mars 2023

2. Markets anticipate a fast decline in short-term rates between 2024 and 2027

The three-month Euribor rate is expected to stand at 4% at the end of 2023, and the market anticipates that it will then gradually decrease towards 2.5% in 2027, with an expected 150 basis points drop over three years.

Source : ESTER et Bloomberg 30/06/2023

This downward expectation on Euribor rates is the immediate result of the inversion of the rates curve, becoming increasingly marked as short-term rates rise and long-term rates stabilize. Between the end of April and the end of June 2023, long-term rates remained steady, but short- and medium-term rates have sharply risen: the curve has pursued its inversion trend.

As the chart below shows, over the past 8 months, long rates in the US and Europe have risen by 113bp and 26bp respectively. This rapid rise comes at a time when neither the Federal Reserve nor the European Central Bank are planning to raise their intervention rates in the next 2 years.

Source : ESTER et Bloomberg 30/06/2023

In the central market scenario, borrowers who will remain on floating rate terms will indeed see their financial costs decline. However, over the long term, such decrease in Euribor 3M rates will not cost them any less than if they had locked in a fixed rate for the whole term. Indeed, this drop in short-term rates has already been incorporated into long-term rates, because the market, as always, equates the long-term value with hedging and that without hedging.

Moreover, this inverted shape does not imply that long-term swap rates will decline in the future, except through the deceptive effect that, when the borrower enforces its hedging instrument in the future, he will cover a period when forwards are lower. Such downward effect of the forward rate is compensated on average by the higher floating coupons paid over the immediate unhedged periods.

Around this central scenario, the markets also allow us to quantify and set probabilities for alternative scenarios. The 10-year swap rate against Euribor 3 months in a one year-time in “central market scenario" is 2.84%, but there is 20% probability, according to markets estimates, that it will be higher than 3.60%, and 20% probability that it will be lower than 2.00%.

Around this central scenario, the markets also allow us to quantify and set probabilities for alternative scenarios

3. Around the central scenario outlined by market forecasts, two economic scenarios are emerging

a) A persistent inflation scenario where expectations for lower rates do not materialize

Some argue that inflation could remain high over the long term due to structural changes such as the slowdown in globalization, the cost of ESG standards and the shock of the fast-moving energy transition, all of which are factors weighing on production costs and pulling up prices. Should the expected decline in inflation not occur as quickly as the markets and the ECB had hoped, and inflation remain persistently high, the ECB would not be able to justify a rate cut, and long-term rates could anchore at a higher level.

b) A sharp recession scenario in Europe leading to a violent drop of interest rates

While it is unlikely that the European Central Bank will lower its key rates before inflation has durably fallen down to around 2%, it is however possible that a severe recession in the Euro zone will lead to a sharp fall of inflation and a rise in the unemployment rate by several points. In order to maintain the economic stability of the zone, the Central Bank would have to lower interest rates brutally. In such a scenario, the rates would decline faster and more substantially than markets currently expect.

We are thus faced with two opposing scenarios, and it is very difficult to set any probabilities on either of them:

• Either economic growth and job market will hold up, and rates will not fall during several quarters; they could even continue to rise after the end of 2023

• Or a severe recession will break out, and rates could then drop again very sharply
  

In such a rather binary context, hedging the interest rate risk with a swap would result in freezing the current level of rates, which provides effective protection against rates increases, but does not allow to take advantage of a potential rates fall in the recession scenario.

On the other hand, taking the decision to wait means accepting a potential additional rise in long-term rates, with the consequential risk of being pressured by lenders to hedge at a later date and at the worst possible time. On the other hand, not hedging immediately means accepting to pay around 4% Euribor by the end of 2023, with little visibility on the ECB's ability to lower rates down swiftly. Failure to hedge could therefore prove very costly in the short term, as Euribor is already much higher than long-term rates.

Fortunately, other hedging strategies would enable to get out of this binary choice of hedging with a swap or waiting.

Which alternative to rate fixing is there for borrowers ?

As an alternative to non-hedging, there are fortunately other strategies that allow to protect against the risk of fixing rates at the worst possible time, while controlling the risks of rates hike.

1. Purchase of a cap

Interest rate caps allow to hedge the risk of rates increasing, while benefiting from lower rates should rates drop again, against the payment of a premium. This type of hedging is usually used in LBO-style financings, but less commonly in project finance, partly because it is poorly represented in financing models [6]. Ex-post, however, the cap proved to be the best-performing hedging instrument on average over the 2000-2020 period.

2. Purchase of a cap partly or wholly financed by the sale of a floor

Collars (purchase of the cap and sale of the floor) offer a greater flexibility than swaps, since the borrower can decouple the level of rate hike protection (the strike of the cap) from the level of rate drop exposure (the strike of the floor).

By using a collar, the borrower benefits from a fall in rates until floor strike and is exposed to rates rise until cap strike.

Remember that a fixed-rate swap is nothing more than a collar, whereby the purchase of the cap and the sale of the floor occur at the same rate level (strike). With a swap, the borrower shall pay the balance in favor of the bank if the floating rate is lower than the fixed rate (strike), similarly as for a sale of a floor.

The collar can be designed so as to be at zero premium [7] by adjusting the level of the upwards and downwards strikes.

The collar can also be at a non-zero premium, for example by buying a cap at a level not too far from the swap level, and by selling at a far enough level in order to benefit from a good protection, while continuing to benefit more broadly from rates drop scenarios. The collar premium can then be paid in a single lump sum or spread over the term of the transaction, such as with spread-premium caps.

Note that since the financing models are based on a determinist scenario, the collar is also represented less favorably than the swap, as the risk of a rate rise is represented in the model via the maximum rate (plus the potential premium) while the potential benefit of a rate fall is not represented.

3. On the contrary, some instruments are much more hazardous

Since the start of the sharp rates hike, some forgotten hedging ideas are reappearing, which may cause major disappointments.

This is the case with " cap spreads" which only protect within a limited rates zone, allowing to limit the cap premium. This is the equivalent of insurance policies which include a large scope of guarantee exclusions.

This is even more the case with "deactivating" caps, which are instruments that disappear when rates reach a given high barrier, and which therefore disappear just when you need them most. Here too, premium is low, even very low, giving the illusion of a protection for a lower price.

Conclusion

Deciding not to hedge interest-rate risks because rates are considered "high", or, in a similar way, unwinding existing hedges in order to "benefit" from a high mark-to-market on the previous hedges, is a hazardous strategy.

Long-term rates are currently at their historical average levels since 1999, and even well below their historical average levels if we exclude periods when the ECB bought assets on a massive scale or distributed cheap liquidity to commercial banks [8].

It is true, however, that, in the context of a major recession in the Euro zone, there is a scenario in which rates might drop again rapidly.

Borrowers have liquid market instruments at their disposal, enabling them to both hedge against rising interest rates scenarios and take advantage of potential rate drops in the future.

ESTER is your partner of choice.

[1] Swap rate 10 has increased by 310 basis points since August 2021

[2] The ECB deposit facility rate has risen from -0.50% to +3.5% in 20 months, and one or two further 0.25% increases are expected by the end of 2023

[3] With the period 2005-2008 (+200 basis points), the period 2011-2013 (+230 basis points) and finally the period 2016-2018 (+90 basis points)

[4] Including food and energy

[5] Excluding food and energy

[6] In project finance models, only the worst case is retained, i.e. the case where the floating rate is fixed at the level of the cap rate, to which the cost of the premium to be paid to purchase the cap, must be added. The model gives therefore no value to scenarios where the floating rate is fixed below the cap rate, while the probability of such scenario is potentially high

[7] In this case, the price difference between the floor sold and the cap purchased corresponds to the transaction costs

[8] Like the FED and the BOE, the ECB has now entered a phase of balance sheet reduction after more than 10 years of liquidity injections and asset purchases in various forms: Quantitative Easing (QE) has given way to Quantitative Tightening (QT), also known as Tapering, with bullish consequences for long-term rates.