Where is inflation going?
US inflation reached 8.5% in March and continues to be there now at a 40-year high. In the most recent report, COVID-19-related supply chain issues coupled with the Russia-Ukraine war have driven energy prices up a staggering 32%. And food prices follow suit, rising 8.8% – the most important increase since 1981. Consumers in every single place are feeling the pressure, and many analysts predict a US recession.
The US Federal Reserve is anxious for good reason.
To curb inflation, the Fed launched a rate hike cycle on the FOMC meeting last March, raising the important thing rate of interest by 25 basis points (bps). And it just delivered what the market expected on the last meeting on May 5: a 50 basis point rate hike. This is more aggressive than the primary rate hike and shows how concerned the central bank is in regards to the evolving inflation outlook.
But what comes next? The market is speculating wildly. There are many questions on the intensity of further rate hikes and whether the economy can withstand a half-dozen hikes this yr without slipping into recession. On the opposite side of the coin, fears of runaway inflation underscore the danger of falling behind. For inflation hawks: Catching up through aggressive rate of interest increases is an absolute necessity.
CPI inflation and employment gains
The Fed’s decisions will significantly impact the outlook for firms and investors alike. How can we hedge against this uncertainty?
With rampant inflation and rising rates of interest, managing financial risk is critical. We should protect ourselves from rate of interest fluctuations, from expected and unexpected rate of interest increases. But how? And with short-term rates of interest soaring, is it too late to hedge our pending debt? How can we prioritize financial risk management goals?
Don’t worry about market developments
Interpreting the Fed’s tone regarding possible rate hikes mustn’t be the main target. Instead, we want to take a better have a look at our company’s risk profile. The greater the leverage on the balance sheet, the harder it’s going to be to soak up rate of interest increases and shocks. However, proper risk management provides each proactive and reactive measures to hedge against such market risks.
Since January 2012, the Fed has published quarterly rate of interest expectations. The so-called dot plot shows the Fed’s expectations of the short-term key rate of interest, which it controls for the following three years and in the long run. The dots show each Fed member’s anonymous vote on the expected rate of interest movement.
While these simply guide the Fed’s actions, some firms mistakenly depend on them to guide their risk management and hedging decisions. But waves of crises and unexpected events often shake up the conspiracies and sometimes prove them improper: in March 2021, for instance, most Fed members expected Zero rate of interest increases in 2022 and 2023!
Just a yr later, the March 2022 dot plot showed a massive shift in Fed expectations: From the March 2021 forecasts of zero rate hikes in 2022 to the March 2022 forecasts of six rate hikes in 2022. And since then, the Fed’s tone has only develop into more hawkish. We shouldn’t give attention to what the Fed guarantees to do; it almost certainly won’t.
Understand your debt risk and sensitivity to rate of interest movements
All businesses should fastidiously plan their current and future debt needs. Managing financial risks becomes easier with a transparent debt plan.
But whether it’s financing an acquisition, refinancing a loan or supporting ambitious capital spending, the hedging strategy requires the utmost attention. Because if the pandemic has taught us anything, it’s that the longer term is totally uncertain.
As a part of the hedging assessment and feasibility process, an entity must develop reasonable expectations for the maturity, amortization schedule and variable rate of interest index and evaluate the tools available to implement the intended hedging strategy.
Go old skool with hedging products!
The alternative of hedging instrument requires close examination and careful consideration to cut back and mitigate market risk arising from rate of interest risk. We can reduce risk by creating an offsetting position to counteract volatilities within the fair value and money flows of the hedged item. This may mean forgoing some winnings to mitigate this risk.
It is all the time advisable to stick with standard instruments to secure our debts. These include rate of interest swaps and rate of interest caps. Future debts can be secured with reasonable security of expected debts. This might be achieved through a forward starting rate of interest swap (simply booking a hard and fast swap rate in the longer term), an rate of interest cap and other easy hedging instruments.
The more complex a hedging instrument becomes, the more challenges it presents when it comes to price transparency, valuation considerations, hedge accounting validity and overall effectiveness. That’s why we should always keep it so simple as possible.
It is unattainable to time the market
“Timing the market is a no-brainer, whereas time in the market will be your greatest natural advantage.” — Nick Murray
The above statement applies to risk management. Companies must avoid trying to find the most effective entry point for hedging. Instead, we should always act based on pre-determined objectives, risk tolerance, hedging parameters and a governance framework.
Consider the present rate of interest environment. For firms which are sensitive to higher rates of interest, management may assume that rate of interest increases are already reflected in or priced into current market levels. Management may not imagine that the yield curve can be costlier in the longer term and will consider purchasing hedge unnecessary.
However, there are hedging products that supply more flexibility in low rate of interest environments while providing upside protection. A hedging policy regulates all of those aspects in additional detail and provides management the needed guidance in order to not depend on subjective and individual decisions.
Why is hedge accounting essential?
When using hedging instruments to guard the corporate from opposed market movements, the accounting implications are crucial.
Proper application of hedge accounting standards reduces financial plan volatility in the corporate’s accounting records. Hedge accounting helps reduce income statement (P&L) volatility attributable to repeated adjustments to the fair value of a hedging instrument (Mark-to-Market – MTM). The critical conditions of the underlying transaction (the liability) and the associated hedging instrument (financial derivatives) should match.
Hedge accounting follows a clearly defined accounting standard that have to be applied for successful designation. Otherwise, the fair value of the hedging instrument would have a direct impact on the income statement. Some institutions prioritize accounting impacts over economic advantages and vice versa. Hedging policy must consider what comes first when it comes to prioritization.
Takeaways
In uncertain times like these, there are countless perspectives on the direction of future market movements. The inflation hawks have gotten more aggressive while the doves are sticking to their pessimistic stance.
Both firms and investors profit from a correct financial risk management plan in good times and bad. Such preparation mitigates the impact of our personal cognitive biases and ensures sustainability and endurance even in probably the most difficult market conditions.
While we won’t and should not insure the whole lot, solid planning promotes a culture of risk management across the organization. Ultimately, nonetheless, the board and leadership team are liable for setting the tone.
Here too, Nick Murray offers some wisdom:
“All financial success comes from implementing a plan. A lot of financial failure comes from reacting to the market.”
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Photo credit: ©Getty Images/Ian Barnes/EyeEm
