The International Implications of Interest Rate Hikes — A WTC Utah Report

Written by Peter Given, global business analyst, and Troy Keller, international trade & commercial policy advisor

Inflation jumped to its highest level since 1981. The April consumer price index (CPI) not only increased 8.3% year-over-year, but between March and April, the month-over-month CPI increased by 0.3%. A recent, primary driver for this is the Ukraine crisis, impacting global energy and food prices. Even core inflation, which excludes volatile food and energy prices, was up 6.2% year-over-year.

Historically, the U.S. Federal Reserve has targeted the domestic inflation rate to be around 2%. With inflation far exceeding this amount, the Fed’s policymakers are expected to deliver a series of aggressive interest rate hikes over the course of 2022 to deal with hot inflation. During their recent Federal Open Market Committee (FOMC) meeting on May 3–4, the Fed decided to raise their benchmark rate by 0.50% to a current target rate of 0.75% to 1.00%. Additionally, the Fed is expected to begin quantitative tightening (QT) as evidenced in their minutes from the March FOMC meeting.

During the pandemic alone, the Fed bought $3.3trn in Treasuries and $1.3trn in mortgage-backed securities (MBS) as they sought to keep borrowing costs low and the economy in healthy shape. QT is the process of shrinking down the Fed’s balance sheet. Historically, the Fed has reinvested the proceeds of maturing bonds in order to maintain its stock of assets. However, as suggested in their March minutes, they are likely to let these maturing bonds “roll off” without reinvestment, rather than selling the bonds that were purchased.

The Fed’s interest rate hikes primarily impact short-term yields — those that affect consumers’ everyday lives — such as the interest on savings accounts, credit card rates, auto loans, and other similar products. QT’s impact is more on long-term yields, such as the interest on mortgages, corporate bonds, and other longer-dated products.

Moreover, interest rate hikes have broad international implications, wherein they generally strengthen the value of the U.S. dollar against other currencies. As a result, this will make imports into the U.S. cheaper and bolster the USD as the reserve currency of the world. However, exports from the U.S. will be more expensive, with emerging economics seeing vastly negative impacts, specifically due to most commodities being priced in USD. With most emerging economies still feeling the effects of the pandemic, specifically low vaccination rates, coupled with higher energy and food prices, we could see a reduction in U.S. export demand and a decrease in global manufacturing capacity.

A step some are calling for to soften the effects of inflation is a re-examination of our tariff policies. Several months ago, World Trade Center Utah floated an idea with policymakers to consider a temporary reprieve on the China-focused Section 301 Tariffs. This idea has been taken up by others in the legislature and even some in the Biden administration. The United States Trade Representative (USTR) is going through its standard review process on Section 301 Tariffs this year, and they will see many calls to provide some relief. We will keep you posted on these developments.

Lastly, there are some indicators signaling a recession could be on the horizon. The U.S. Commerce Department released Q1’s GDP figures on April 28, which unexpectedly declined at a 1.4% annualized pace. Additionally, the spread between the two-year and 10-year Treasury yields recently inverted for a brief period at the beginning of April. This part of the yield curve is most closely watched, and typically given the most credence by investors, as it signals the economy could be heading for a downturn when it inverts. This occurs when the yield of the two-year Treasury rises above the yield of the 10-year Treasury. According to data from Credit Suisse, the inverted yield curve preceded the last five recessions with a recession occurring on average 22 months following the inversion.

 

 

 

 

What Can Companies Do?

Managing exposure to climbing interest rates can be done in a number of ways. The first step is to simply reach out to your bank to see what it would cost to convert your floating rate debt into a fixed rate, or what other options they might have for you. Often, the cost to convert is more than what you expect the cost of increased rates will be, but it is worth asking the question.

Another way to offset your variable rate exposure is to look at where your cash is sitting and consider putting it into more variable instruments where the returns will increase with broader market rate increases. This can act as a natural hedge against interest rate increases on your corporate debt.

It’s also worth re-evaluating your working capital. During times of expansion, capturing market share is the priority. However, in times of contraction, reducing working capital may be a more important priority for you. Improving the speed of collections of receivables on the one hand, while reducing the amount of inventory and extending payables on the other, are typical ways of managing against uncertainties in both interest rates and exchange rates. Don’t forget, however, that times of contraction can also be growth opportunities — particularly if your peers are more cash constrained than you.

Finally, a currency hedging strategy may make sense if your sales tend to be into a particular foreign market and you are paid in that market’s currency. A hedge will provide protection against fluctuations in the exchange rate due to a strengthening of the dollar. But don’t go all in. While it’s good to take some exposure off the table, if you try to hedge 100%, you are in effect simply trading one set of risks for another.

 

Stay Nimble

While there is a fair amount of pessimism in the markets right now — as we’ve seen in the past and in extreme ways in 2020 — market outlooks can change on a dime. Taking steps to hedge risk are important, but many of these steps involve locking yourself into a particular view of how the future will play out. It is usually better to take some risk off the table but retain the ability to react and grow.