It’s been a good year for most US corporates, as the economy continues to power ahead and they enjoy the largesse of the president’s corporate tax cuts. But there are red flags on the horizon.
Donald Trump doesn’t like higher interest rates. There have been some strident reminders of that fact recently, with the president even accusing the Federal Reserve of being “out of control”. However, regardless of the castigation issuing from the White House, the Fed seems likely to continue its policy of steadily hiking US rates in quarter point increments. The next increase has been pencilled in by analysts for December, with the likelihood that three more will follow in 2019.
“The big picture is that the US economic recovery is well advanced compared to that in Europe,” says Peter Seward, Vice President of Market Development, Risk at GTreasury. “If the return to the more normal conditions of the pre-crisis period describes a giant U curve, then we’re halfway back up from its depths. The big question now is how much further back up the curve we’ll go.”
“It has been assumed that the current tightening cycle won’t see rates reach the heights of the pre-2008 period, but these assumptions now seem less certain,” he adds. “And everyone agrees that further increases are a certainty.”
A further 0.25% hike before the end of the year would take the US benchmark rate to a range of 2.25%-2.50% compared to the pre-2008 peak of 5.25%. The past decade has seen total US corporate debt rise further with companies adding more than US$2.5trn to their balance sheets, which collectively now hold debt of over US$9trn.
The impact of what Seward calls “the Fed’s interest rate end game” is unclear and complicated by factors that include the heated rhetoric fuelling growing trade wars, volatility in the emerging markets and the European Central Bank’s (ECB) intention to wind up its quantitative easing (QE) programme – which has involved €2.5trn of bond buying – at the end of this year.
Corporates also need to keep an eye on the US inflation rate, which at around 2% has stayed relatively subdued since briefly dipping into negative territory during the 2014-15 energy price slump but is now poised to move higher as the continued fall in unemployment points to future wage pressures.
Throw into this mix such alarming, but feasible scenarios as the policy of steady tightening triggering a fresh credit crisis. Add the possibility that China might respond to tariffs on its goods by weaning itself off an appetite for US bonds and the near future could prove truly alarming. As holder of around US$1.2trn in treasuries, the US’s biggest economic competitor is also its biggest creditor. Add nine other major Asian economies and that total holding rises to more than US$3trn, or nearly 15% of total US national debt.
Gauging the future
Given the uncertainty, treasurers and chief financial officers (CFOs) at US corporates have an increasingly complicated task in assessing their future cost of funds. Should they opt to roll over their hedged debt as rates move upwards and existing exposures mature, even if maturity is within the next 12 or 24 months?
In GTreasury’s recently-published white paper, Seward examines the implications for US companies of failing to hedge a roll-over facility. It takes the example of the average corporate, with a revolving floating rate line of credit entered into a few years ago and whose renewal date is fast approaching.
For a three-year US$500m floating rate facility taken out at the start of 2017 and maturing at end of next year, assuming it was hedged at inception all is well in the near term. The hedge continues in place until the facility matures at the end of 2019. However, a significant increase on effective rates then occurs in 2020 regardless of future hedging, as the market has moved significantly from successive Fed rate hikes over the intervening three years.
What’s more, further increases in effective rates occur as the Libor rates increase if – as seems highly probable – the Fed raises rates further between now and the end of 2019. A webinar poll of treasurers by GTreasury and Strategic Treasurer found that while more than half anticipated a further 50-100 basis points (bps) increase, nearly 30% expected credit crisis rates to return.
“Based on the most likely direction of the Fed’s rate tightening policy, the impact on US corporates of deciding not to hedge is that they stand to lose around two-thirds of the benefits provided by the corporate tax cuts introduced earlier this year,” says Seward. “Recognising this, a number of companies are already taking out forward swaps and locking in rates.
“It’s possible now to hedge with forward-style transactions and some corporates have decided to move early to shield themselves from further rate hikes and higher borrowing costs. However, there are also more than a few with substantial debt loads that prefer to stay floating 100%.” Whether this latter group can afford to remain unhedged looks increasingly in doubt.