Where is inflation going?
US inflation hit 8.5% in March and is now at a 40-year high. Supply chain issues related to COVID-19, combined with the war between Russia and Ukraine, have pushed energy prices up a staggering 32% in the latest report. And food prices follow, up 8.8%, the biggest jump since 1981. Consumers everywhere are feeling the pressure, with many analysts predicting a recession in the United States.
With good reason, the US Federal Reserve is concerned.
To curb inflation, the Fed began a hike cycle at the FOMC meeting last March, raising the federal funds rate by 25 basis points (bps). And it just delivered on what the market expected at the last meeting on May 5: a 50bp rate hike. This is more aggressive than the first hike and shows how alarmed the central bank is about the evolution of the inflation outlook.
But what comes next? The market is speculating heavily. Questions abound about the intensity of further rate hikes and whether the economy can withstand a half-dozen hikes this year without slipping into recession. On the other side of the coin, fears of runaway inflation emphasize the danger of getting stuck behind the curve. For inflation hawks, catching up through aggressive rate hikes is an absolute must.
CPI inflation and employment gains
The Fed’s decisions will significantly affect the outlook for both companies and investors. So how can we hedge this uncertainty?
Amid rampant inflation and rising interest rates, financial risk management is critical. We must protect ourselves from the volatility of interest rates, from anticipated and unanticipated increases. But how? And given how quickly short-term rates have risen, is it too late to cover our floating debt? How can we prioritize financial risk management objectives?
Don’t obsess over market trends
Interpreting the Fed’s tone around possible rate hikes should not be the main focus. Instead, we need to look closer to home, the risk profile of our company. The more leveraged the balance sheet, the more difficult it is to absorb rate hikes and shocks. However, proper risk management provides proactive and reactive measures to cover these market risks.
Since January 2012, the Fed has published interest rate expectations every quarter. The so-called Dot Plot shows the Fed’s expectations for the key short-term interest rate it controls for the next three years and the longer term. The dots show each Fed member’s anonymous vote on the expected rate move.
Although these only guide the Fed’s actions, some corporations mistakenly rely on them to inform their risk management and hedging decisions. However, waves of crises and unexpected events often overturn plots and often prove them wrong: in March 2021, for example, most Fed members expected zero rate hikes in 2022 and 2023!
Just one year later, the March 2022 Dot Plot showed a massive shift in Fed expectations: from March 2021 forecasts of zero rate hikes in 2022 to March 2022 forecasts of six hikes in 2022. And since then, the Fed’s tone has only grown more dovish. hawk We should not focus on what the Fed says it will do; most likely won’t.
It includes exposure to debt and sensitivity to interest rate movements
All businesses should carefully plan their current and future debt requirements. Managing financial risks is made easier with a clear debt plan.
But whether it’s financing an acquisition, refinancing a loan or supporting an ambitious capital expenditure, the hedging strategy requires the utmost attention. After all, if the pandemic has taught us anything, it is that the future is radically uncertain.
As part of the hedge feasibility and evaluation process, a company should generate reasonable expectations about the duration, repayment schedule and variable interest rate index and evaluate the tools available to implement its strategy of expected coverage.
Go old school with coverage products!
The choice of hedging instrument requires great scrutiny and careful considerations to reduce and mitigate market risk arising from interest rate exposure. We can reduce risk by creating an offsetting position to offset the volatilities exhibited 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 by a fair guarantee of the expected debt. A forward to forward interest rate swap (simply booking a fixed swap rate in 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, validity of hedge accounting and overall effectiveness. So we should keep it as simple as we can.
It is impossible to time the market
“Market timing is a fool’s game, while timing the market will be your greatest natural advantage.” —Nick Murray
The above statement applies to risk management. Companies should avoid trying to solve the best coverage entry point. Instead, we should act based on pre-set targets, risk tolerance, hedging parameters and a governance framework.
Consider the current interest rate environment. In companies that are sensitive to higher interest rates, management might think that rate hikes are already reflected, or priced in, at current market levels. Management may not believe that the interest rate curve will become more expensive in the future and may think that buying a hedge is unnecessary.
However, there are hedging products that offer more flexibility during lower rate environments while still offering upside protection. A coverage policy regulates all these factors in more detail and provides management with the necessary guidance to avoid relying on subjective and individual decisions.
Why is hedge accounting important?
When hedging instruments are used to protect the company from adverse market movements, the accounting implications are critical.
The proper application of hedge accounting rules reduces the volatility of financial statements in the company’s accounting. Hedge accounting helps reduce the volatility of the profit and loss account (P&L) created by the repeated adjustment to the fair value of a hedging instrument (mark-to-market – MTM). The critical terms of the hedged item (the debt) and its associated hedging instrument (financial derivatives) should match.
Hedge accounting follows a well-defined accounting standard that must be applied for a successful designation. Otherwise, the fair value of the hedging instrument would directly affect the income statement. Some institutions prioritize accounting implications over financial benefits and vice versa. Coverage policy should address what comes first in terms of prioritization.
Takeaway food
In times of uncertainty like these, there are countless perspectives on the direction of future market movements. Inflation hawks are becoming more hawkish, while doves remain steadfast in their bearish stance.
Both corporations and investors reap the benefits of a proper financial risk management plan during good times and bad. This preparation mitigates the effects of our personal cognitive biases and ensures sustainability and resilience during the most challenging market conditions.
While we can’t and shouldn’t cover everything, solid planning cultivates a culture of risk management throughout the company. Ultimately, however, the board of directors and the executive team are responsible for setting the tone.
Again, Nick Murray offers some wisdom:
“All financial success comes from acting on a plan. Many financial failures come from reacting to the market.”
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: ©Getty Images/Ian Barnes/EyeEm
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Muadh Alhusaini, CFA, FRM, CAIA
