Interest rate collars gain appeal as rate cut uncertainty ensues

Powell twice indicated rate cuts are not imminent, and the market had a mixed reaction

On Wednesday, the Federal Open Market Committee (FOMC) voted unanimously to hold the federal funds rate at a target range of 5.25% – 5.50%. The FOMC also recognized, for the first time in this rate cycle, that inflation goals are “moving into better balance.” The committee subsequently removed language associated with additional rate hikes in favor of the following language that the federal funds rate will remain constant for the near future: “The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward two percent.”

During his press conference, Chair Powell reiterated multiple times that the last six months of inflation data is not enough to ensure sufficient “confidence” within the FOMC that inflation is on a sustained trajectory towards their 2.00% inflationary target. When pressed further about the timing of rate cuts, Powell broke from his standard practice of avoiding provided timeframes and told reporters, “Based on the meeting today, I would tell you that I don’t think it’s likely that the Committee will reach a level of confidence by the time of the March meeting to identify March as the time to do that [cut rates], but that’s - that’s to be seen.”

Despite the relatively Hawkish commentary from Powell, indicating rate cuts were further away than the market predicted originally, rates fell for the day on Wednesday. The 2-year treasury rate closed 0.60 basis points lower, and the 10-year treasury fell roughly 3 basis points.

On Sunday, Powell again reiterated the Fed’s hesitation to cut rates imminently on a "60 Minutes” interview. He stated, “We think the economy’s in a good place. We think inflation is coming down. We just want to gain a little more confidence that it’s coming down in a sustainable way.” The market responded mildly to the additional comment, despite largely ignoring it on Wednesday. The 2-year treasury rate jumped about 6 basis points in the morning on Monday, February 5. The 10-year treasury was up about 10 basis points.

Interest rates jumped Friday after a strong jobs report

The Employment Situation Summary reported that 353,000 nonfarm jobs were added in January, nearly double the market estimate of 185,000. It was the largest gain the U.S. economy has posted since January 2023. Meanwhile, wage growth posted its largest month-over-month increase since March 2022 at 0.60%, which resulted in an annual increase in wages of 4.50%. The unemployment rate remained unchanged at 3.70% for the third consecutive month.

The large jump in both jobs and wages suggests the U.S. economy remains on a solid growth trajectory and poised for continued real GDP growth, particularly from consumer expenditure. For perspective, 60% of the real, 2.50% GDP growth last year came entirely from consumer spending. With strong jobs growth and wage growth (4.48%) continuing to outpace inflation (3.35%), it is increasingly likely that the consumer will continue to boost economic output. Consumers also continue to notice the improving economic conditions. In the Michigan Consumer Sentiment Survey, consumer expectations for the next year of inflation decreased from 3.10% to 2.90%, the lowest level since February 2021, and their overall sentiment increased to 79.00 in January, the highest level since July 2021.

Although great for consumers and the overall economy, the positive economic data releases suggest the Fed will need to keep rates higher for longer. A stronger labor market with strong real wage growth suggests that consumers have the potential to reignite inflation, which to Powell’s point is why the Fed does not consider six months of declining inflation sufficient to cut rates. Because of the news, rates spiked on Friday. The 2-year Treasury rate closed at 4.36%, up 16 basis points. It was the largest jump in the 2-year yield since April.

Inflation escalation remains a possibility

Despite the economic updates and Fed commentary, investors still broadly believe rate cuts are imminent. As of Monday's open, the market still projected five rate cuts of 25-basis points for 2024, according to CME futures data, despite the Fed’s expectation to cut rates just three times. Even with Powell directly telling markets a rate cut in March was unlikely, over 18.00% of market participants still anticipated it would occur as of Monday, February 5.

To the market’s credit, rate cuts certainly seem to be the most likely outcome over the coming months. Over the last six months, on an annualized basis, core PCE inflation fell to 1.90%. Even with robust job and wage growth, GDP cooled from an annualized 4.90% in the third quarter of 2023 to 3.30% in the fourth quarter. Looking forward, the annualized pace of GDP is expected to be 1.00% in the first quarter of 2024 and 0.50% in the second quarter, according to a Bloomberg survey of banks. However, risks of inflation are still prevalent throughout the global economy from both a supply and demand perspective.

Consumers could plausibly use their real wages to continue to boost the economy beyond expectations. Notably, at this point last year, a Bloomberg survey of banks expected third-quarter GDP growth in 2023 to be -0.20%; it was instead 4.90%. The consumer could also get an additional boost from Congress. Via a bipartisan vote, the House of Representatives passed a tax cut worth nearly $60 billion, which would immediately benefit many citizens and businesses within the next few months if it becomes law. Setting the U.S. consumer aside and looking globally, the conflict in the Middle East is already impacting the supply chain. Many cargo ships are being forced to travel around the Cape of Good Hope, in Africa, rather than through the Red Sea. As a result, the cost to ship a 40-foot container has nearly tripled from $1,381 in November to $3,823 as of February, according to Drewery reports,. Nearly 80.00% of all global trade utilizes cargo ships, so any further escalation could certainly spur additional inflation in the U.S. Although the market is currently shrugging it off, inflationary risks remain prevalent.

Costless collars gain traction

The current market environment makes interest rate collars a popular alternative among organizations with floating-rate debt. Collars are becoming increasingly attractive due to the following dynamics:

• Executing a costless collar requires no upfront premium payment.
• Collars provide organizations with a known best-case and worst-case interest rate payment on their underlying floating rate debt.
• Collars protect organizations from the Fed holding rates higher for longer or increasing interest rates in the event inflation were to re-accelerate.
• Collars allow organizations to reduce their interest expense if rates fall over the coming years relative to utilizing a swap.
• If interest rates follow the forward curve, executing a zero-cost collar, exclusive of fees, provides organizations with an expected present value cash flow gain over the next three years due to current market dynamics.
• Any cash flow pickup is expected to occur within the next eight months due to the inverted yield curve.

For perspective, the table below compares the interest expense for a $100 million term loan over three years (exclusive of borrowing spread) between executing a swap and a zero-cost collar.

The reason collars are particularly beneficial in today’s market environment and provide a net present value gain if rates follow the forward curve is due to current volatility. Since the market is expecting rates to fall significantly more than they are expecting them to rise, volatility pricing is higher for floor options as compared to cap options over the next three years. The average volatility for a sold 2.765% floor option over the three-year time period is 34.89%. The average volatility for a bought call option over that same timeframe is just 23.62%. This market dynamic means that an organization that sells a floor and buys a cap, creating a costless collar, can receive a cash flow benefit from the volatility mismatch and gain protection from the Fed keeping rates higher for longer. Below is a table detailing two costless collar examples at mid-market levels, exclusive of any bank charges, as of 2/4/2024.

The present value cash flow pickup assumes rates follow the forward curve. For every month that the Fed chooses to either keep the Federal Funds rate above 5.0%, the corporate holding either collar detailed above would expect to receive a payment, since 1-month Term SOFR is highly correlated with the Fed Funds rate. The current Fed Funds rate is 5.25%-5.50%. As a result of the current forward curve, the anticipated cash flow of the 4.75% bought cap and 2.77% sold floor is shown below. Since the forward curve is based on the five anticipated rate cuts this year, if the Fed holds rates higher for longer or increases rates, the payoffs detailed in the table above and the graph below would be even higher.

Before entering any collar, organizations should always consider the following:

• If rates fall below the sold floor strike rate of a collar, the organization will be required to pay the difference between the 1-month Term SOFR rate and their sold floor strike rate. Based on the current forward curve, that is not expected to happen. Likewise, based on the most recent summary of economic projections, the FOMC expects the fed funds rate to be at least 2.90% until 2027. However, a recession or dramatically falling inflation could prompt more cuts than expected by both the market and FOMC. Any payment made on the collar would also be offset by reduced interest paid on the underlying floating rate debt.
• Collars are expensive to execute. Although no upfront premium is required, the organization will need to pay basis point fees, which will be baked into the collar strike rates, associated with both buying a cap and selling a floor.
• If organizations are confident rates will stay higher for longer, an interest rate swap would be more beneficial than a collar.

Given the current uncertainty in interest rate markets and the current volatility imbalance between cap and floor options, collars provide an opportunity for organizations to have costless protection on their floating rate debt with known best- and worst-case scenarios.