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June 2010

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Editorial

Time to prepare for possible rate hikes?

How can you sift through the confusion on the global outlook and be prepared for whatever the future may bring? There are always two schools of thought. Currently, pessimists believe the danger is very real, that the Eurozone is falling apart and the China bubble is about to burst. They think the US will remain lacklustre, and the level of debt in many countries is unsustainable and will therefore cause further financial chaos. Optimists believe that the European crisis is a storm in a teacup, largely driven by fear. They would say Greece was never going to default or leave the euro, but Europe and the IMF had to reassure against the irrational fear in the markets. The optimists’ belief is that China is not a bubble and we are looking at a period of ten to 15 years of uninterrupted growth in Asia. Global growth will exceed expectations, bringing in higher tax revenues than planned and therefore the fiscal situation of highly indebted countries will be much less worrying than previously thought. The first school of thought means almost zero interest rates for some time to come and the second, may mean significant rate rises.

Whatever you believe, should that view shape your financial decisions? We’ve been talking to a number of treasurers worldwide in the past three months and many are cautiously optimistic about recovery and growth prospects, despite the Greek debacle of recent months. And because many companies believe, like governments do, that growth equals inflation – and therefore interest rates must rise accordingly– treasurers are factoring in future rate rises into financial decisions. Should you be doing something now to manage your interest rate exposure?

Most professionals in the treasury field will tell you that it is not the treasurer’s job to take positions. Views are best left to the markets. Unfortunately, there is really no such thing as a neutral position in treasury. By holding onto cash at the moment, a company has de facto taken one. Those who have borrowed now at low rates, to avoid interest rate rises later (and have a large cost of carry – since the funds are remaining idle in many instances), have also taken a view. Keeping your investment short term because you think interest rates will rise is taking a position; likewise when you borrow, and decide on the balance of how much floating and how much fixed term, is yet again taking a view. Some companies say that they are fundamentally conservative and therefore do not hedge. By not hedging, a company is taking a position.

In the past few years, many companies have been caught out with currency volatility, leading to a huge impact on the P&L’s bottom line. The same could happen with interest rates. There is a school of thought that central banks manage countries with a dated equation from the 1960s: where growth equalled inflation. So the moment the euro recovers, fear resides and growth kicks in, banks will hike rates to pre-empt inflation. This familiar approach may no longer be the right one. The world has become much more self regulating on interest rates. So we could see governments rather quickly reverse those rate hikes when inflation data doesn’t support their assumptions. This in turn, could lead to volatility in interest rates worldwide in the short term.

So the real challenge as a corporation is rigorously understanding your actual and implied positions, managing duration and understanding what the impact will be if the picture changes. Companies should try to remain as neutral as possible but play out scenarios based on changing circumstances. Forecasts should include making assumptions on various interest rate scenarios and how that may affect liquidity. Be careful about the duration of your funding profile: remember the importance of asset liability matching. Be careful to review your company’s derivative portfolio: watch for embedded interest rates on swaps and forwards and the timing on those. Look at the accounting policies to ensure what you think is a hedge, is indeed a hedge, particularly if you are using interest rate swaps.