Bloomberg Business reports that futures traders think there is a 70% chance the Federal Reserve will increase interest rates this week.
Given that the Fed hasn’t touched interest rates since 2006, derivatives marketers may be asking: what would a tightening of credit mean for interest rate swap payouts? Will the usual cost benefit of floating rates hold true?
In case you’re not familiar with the interest rate term premium, over 90% of the time fixed-rate financing is more expensive than floating for a five-year trade. That’s pretty high; on a roulette table, if you had a 90% chance of winning every time you bet on red, you’d be a fool to choose black.
This floating-rate benefit exists because more often than not, short-term rates are over-predicted by forward rates. You can see this in the chart below comparing historical three month LIBOR forwards vs. realized spot rates over time. As fixed swap rates are based on the time-adjusted average of these “hairs”, there are only a few times when fixed-rate financing is cheaper than floating.
Quantifying the interest rate savings of paying floating- vs. fixed-rate interest historically, we can evaluate the distribution of savings and losses on five-year interest rate swaps.
The above shows that floating-rate financing has produced an average net interest expense saving of almost 2% per year, with over 90% of monthly historical observations associated with floating being cheaper than fixed.
But if the Fed decides to increase rates this week, will this bias still exist? That is, should you start betting on black?
If we extend the savings and losses over the past 50-odd years (using Treasury data as a proxy for swap rate data prior to 1989) and overlay Fed tightening cycles in the background, you can see when the benefit of floating-rate financing shifts, and that in fact, losses on swaps to floating are concentrated around the onset of a series of Fed rate hikes.
Lets now focus on the what happens to the floating-rate benefit in the months before and after Fed fund hikes.
Adding two to ten-year maturities for 300 days either side of these hikes, it’s noticeable that the floating-rate benefit breaks down for short-dated horizons around Fed tightening cycles. There is an approximate 3-month window before the first of a series of Fed interest rate hikes when switching to floating from fixed-rate has been a costly move. If this is the week the Fed decides to take action, consider locking in short-dated fixed rates for your clients, or risk losing them money.
If you would like to get up to speed on interest rate premiums and analysis, email me for an intro series at email@example.com.
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Data source: Bloomberg