Navigating 2024’s Rate Volatility: 3 Key Risk Management Strategies Takeaways

In a recent webinar titled, “Interest Rate Risk Resolutions” our leading experts Isaac Wheeler, Head of Balance Sheet Strategy; Chris Slusher, Head of Rates; and Frank Fiorilli, Director, Sales and Structuring; discussed strategies intended to shield against interest rate fluctuations to effectively navigate the shifting rate environment in 2024.

As we enter 2024, it appears as though easing inflation could be paving the way for lower rates:

• Inflation nearing Fed’s target. The Federal Reserve’s preferred inflation gauge rose only .1% in November—the smallest monthly increase since 2020.
• Labor market remains healthy. The U.S. economy added 216K jobs in December and 335k job in January while the unemployment rate remained steady near a 54-year low at 3.7%. Wage gains are now outpacing inflation for the first time since 2021.
• Soft landing within reach. Despite widespread recession fears, U.S. growth has exceeded expectations. U.S. real GDP grew at a 4.9% annualized rate in Q3 and 3.3% in Q4 .
• Fed rate hikes may be over. After raising the Fed Funds rate by 525 bp since March 2022 in the largest and most rapid rate hike in 40+ years, Fed officials are signaling that they are prepared to loosen monetary policy in 2024.
• Market expects faster rate normalization than the Fed. The market forward curve is currently projecting a much faster pace of rate cuts than implied by Fed forecasts.

As we move forward into 2024, here are three resolutions to consider that can help position your institution for success in 2024.

Resolution 1: understand the limitations of the forward curve

The market forward curve is pricing in six rate cuts in 2024. However, as we benchmark for possible rate drops, remember that the forward curve should not be treated as a prediction. It’s a derived metric that has largely proven to be a poor indicator of the actual path of rates.

Institutions with customer hedging programs should recall the perils of turning off a swap program in 2019 and 2020. That said, the forward curve should also present an opportunity for institutions to eliminate uncertainty for customers with blends and forward locks. For example, whether you have fixed rate loans, loans that are set to reset at the end of a 5-year period, or low maturity loans with rate resets coming in 1-2 years, you could consider looking at applying a forward starting swap to start at the end of that period. This locks in that current post-2025 flatness in the curve at an attractive market rate for customers.

From a balance sheet hedging standpoint, the forward curve can be used as a tool to understand trade-offs in hedge strategies. However, it may be a poor predictor of the path of rates. Institutions should also be aware of divergences between the market’s forward curve and the base scenarios used in internal interest rate risk models. Significant differences between the two can make some strategies appear overly attractive or unattractive.

Resolution 2: consider options as alternatives to swaps

Given the unpredictability of the Fed’s decisions, flexible and diverse hedging strategies are now more relevant. Many borrowers and risk managers are looking for greater flexibility than could be provided by a conventional swap. Options are most valuable when balance sheet uncertainty is highest, so we’re seeing an environment where option-based strategies may have a great deal of appeal.  

Customers can be weary of potential swap unwind fees in an environment where rates could decline. To address these objections, you may consider diversifying your customer swap offering to include caps and collars.  

From a balance sheet hedging standpoint, options structures may become increasingly relevant. Options provide one-way protection, which may be especially attractive given the uncertainty around interest rate risk profiles. Lastly, don’t write off options because of their purported “cost”—all hedges have costs, even those without explicit upfront premiums. 

Resolution 3: focus on risk management, not market timing

Interest rate volatility has been extraordinary in recent years and has increased substantially since pre-pandemic lows. In such a volatile environment, institutions should consider practicing discipline and avoid the temptation to time the market and manage interest rate differentials instead of spreads. Hedging programs — both for customers and for an institution’s own balance sheet are not an on-and-off switch depending on your market view. It is a systematic approach to doing business, looking at risk and hedging it as it materializes. It helps protect against the temptation to try to market time.

A risk management mindset for long-term health

Banks that maintain consistent risk management programs should be best positioned to manage interest rate movements. The long-term business of banking is mostly a business of managing spreads, not absolute rates. When you’re originating a new asset, whether that’s buying a bond for your balance sheet or a new fixed-rate loan, many high-performing banks recognize that more important than the rate itself is how that spread compares to your cost of funds. Institutions should not let their lending portfolios dictate. Instead, they should consider becoming proactive in mining existing hedge portfolios for opportunities, hedge interest rate risk as it materializes, and align lending teams with their broader risk management approaches. By adhering to these resolutions, financial institutions can better strengthen their resilience against rate volatility, ensuring long-term stability and success. 

If you have questions or comments, contact us here. We are always interested in hearing from you.

Key Takeaways

1. It appears as though easing inflation could be paving the way for lower rates, but given the unpredictability of the Fed’s decisions, flexible and diverse hedging strategies may now be more relevant than ever
2. The forward curve should be used as a tool to understand trade-offs in hedge strategies rather than as a prediction for the path of rates
3. Options may be most valuable when balance sheet uncertainty is highest, so we’re seeing an environment where option-based strategies may have more appeal
4. In a volatile rates environment, institutions should practice discipline and consider avoiding the temptation to time the market, and manage interest rate differentials instead of spreads
5. Institutions should consider being proactive in mining existing hedge portfolios for opportunities, hedge interest rate risk as it materializes, and align lending teams with their broader risk management approaches