Derivative Dialogues: Navigating the Rates Landscape

The Federal Reserve’s latest 25 bp rate hike on July 26^th has pushed short-term interest rates to the highest level in 22 years. While the current consensus is that rates may have peaked, Fed Chair Jerome Powell’s recent comments suggest that the central bank is not in any hurry to lower rates.

ZN: What challenges have lenders encountered in this environment of rapidly rising rates?

CS: The dramatic surge in rates over the past 15 months has created several challenges for lenders, including higher deposit costs, losses on their investment portfolios, and reduced loan demand from their borrowers. Lenders also have had to reassess the credit quality of their loan portfolios, given the potential strains that higher rates and a weaker economy may create for their borrowers.

ZN: What are the implications for banks’ funding costs?

CS: In the immediate aftermath of the pandemic, most U.S. banks were flush with liquidity. Loan-to-deposit ratios plummeted to record lows. Banks expected those conditions to persist. However, as rates rose, those excess deposits ran off much faster than anticipated, prompting a renewed focus on liquidity. Banks are being forced to pay higher rates to retain their deposits and are tapping more-expensive wholesale funding sources to meet shortfalls.

ZN: How have banks adapted to these challenges?

CS: Faced with higher funding costs and concerns over a potential economic downturn, banks have widened credit spreads and tightened lending standards. Lenders have had to become more creative to get deals done in the current higher-rate environment, often employing derivatives-based strategies to help their clients achieve their rate objectives. We are also seeing more banks explicitly linking loan pricing to the level of deposits that the borrower holds with that institution.

ZN: How have higher rates impacted borrowers?

CS: The sharp rise in rates initially triggered “sticker shock” for many borrowers who saw their borrowing costs more than double over the past year. Higher rates have prompted borrowers to scale back on leverage. and made some projects less economically viable.

ZN: Given recent conversations about a potential recession or at least a period of sluggish growth, how has this speculation impacted rates?

CS: Contrary to widespread fears of an imminent recession at the outset of the Fed’s tightening cycle, the economy has displayed impressive resilience. Employment and growth remain robust despite significantly higher rates. , and price pressures are finally abating. Headline consumer price inflation has declined to 3% y/y from a high of more than 9% a year ago. The improving outlook for inflation has reinforced expectations that the Fed may lower rates next year, resulting in a steeply inverted yield curve in which long-term rates are lower than short-term rates.  Though short-term rates are higher today, when the Fed does eventually cut rates, it is likely that the short end of the curve will see larger declines than the long end.

ZN: Why is there an increased emphasis on bracing for the next downturn in this current rate environment?

CS: The current rate environment has yielded windfalls for some banks, especially those with asset-sensitive profiles, resulting in wider net interest margins. However, these gains could evaporate if short-term rates subsequently decline, putting pressure on margins. Consequently, some banks are taking advantage of the current rate landscape to implement strategies to hedge against falling rates such as purchasing floors or entering into receive-fixed swaps.

ZN: Amid the challenges of this volatile environment, are there any silver linings in the industry?

CS: Despite these current challenges, the economy and deal-making activity remains buoyant, a promising sign for the industry. Banks and borrowers have become more vigilant about interest rate risk and have implemented strategies to protect their balance sheets against continued volatility. Banks are still recording profits, and borrowing activity persists. The predicted doom and gloom scenarios have not materialized, with borrowers adapting and exhibiting resilience. This trend bodes well for both the economy and the banking sector.