Hawkish Fed to accelerate tapering, sees multiple hikes in 2022 - USD Interest Rates Update
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USD Interest Rates Update
December 2021
Hawkish Fed to accelerate
tapering, sees multiple hikes in
2022
AUB Group
Treasury Sales Team
Interest Rate Risk Management Solutions
1
Executive summary
Background
The Federal Open Market Committee’s recent policy meeting ended on December 15, 2021. Given below are the key takeaways from same;
▪ The Fed’s view that inflation is “transitory” is officially over. The FOMC made its biggest pivot to a hawkish policy in at least the past decade,
responding to inflation running at the highest level in nearly 40 years. The committee doubled the pace of its tapering of asset purchases and
altered its statement to drop “transitory,” and participants forecast three interest rate hikes in 2022.
▪ Powell says he came to the conclusion that a faster taper was necessary after the very hot October consumer price report. The FOMC will be
scaling back purchases of Treasuries and mortgage-backed securities $30 billion a month, putting it on track to conclude the program in
March, rather than mid-year as initially planned. The FOMC also has begun discussing when to shrink the balance sheet.
▪ Projections also showed three more quarter-point hikes in 2023, a much faster pace than envisioned just three months earlier. While Powell
said the rate forecasts are not a plan and represent individual forecasts, he seemed to embrace them. The FOMC statement tied liftoff of rate
hikes to full employment, and Powell said that type of job market seems very close right now. He cited hot labor market indicators such as
the quit rate, big wage gains and record job openings all indicating a strong market.
▪ Inflation is most likely going to be coming down somewhat in 2022, both because of supply bottlenecks easing and because of Fed policy,
Powell said. But there is a real risk that higher prices could be more persistent and become more entrenched, which is why the Fed pivoted
with its policy. Powell said omicron remains a risk to the economic outlook, but Americans are increasingly learning to live with each new
wave of Covid.
Interest rate strategy
In the midst of a heightened uncertainty, we keep seeing selective opportunities in the current market environment:
❑ hedge medium to long-term risk via Interest Rate Swap to take advantage of the current low-rate environment: with Fed rates close to zero
this provides a very good entry point for clients looking to hedge their long-term floating rate exposures;
❑ along the same lines, forward-starting IRS seem to offer decent value given the relatively flat yield curve;
❑ alternative hedging strategy structured via options (like Interest Rate Collar).
2
Interest Rate Markets
3
December Fed meeting update
Fed speeds its bond buying, expects rate hikes
▪ Fed Chair Jerome Powell and his colleagues on the Federal Open
Market Committee decided to double the pace at which they are
winding down their bond-buying program, putting them on track to
wrap it up by mid-March, and signaled they expected three increases in
their benchmark federal funds rate would probably be appropriate in
2022.
▪ Powell said that policy makers eventually “expect a gradual rate of
policy firming.” They don’t anticipate raising rates before ending the
taper process, but could hike before reaching full employment, he
added.
Economic assessment shows solid growth as 2021’s end nears
▪ After a slowdown in the third quarter, the U.S. economy is now on
track for a strong finish to 2021 and a solid start to 2022 as consumers
and businesses keep spending despite high inflation, staffing
challenges, persistent Covid-19 infections and lingering supply
constraints.
▪ Federal Reserve Chair Jerome Powell said he is comfortable the
economy can handle the omicron variant despite current uncertainty.
He also said, the population has increasingly learned to live with it and
people are getting vaccinated.
Market reaction
▪ Financial markets took the shift in the Fed’s rhetoric in stride, with
investors expecting that the central bank can pull off a proverbial soft
landing of the economy. However, bond traders suspect the Federal
Reserve will quickly discover it is being too ambitious with its newly
hawkish stance. Only two days after one of the Fed’s most hawkish
pivots, rates market is already calling the central bank’s bluff. Stock
prices posted the biggest rally since 2020 on the day of a Fed decision.
Data source: Bloomberg
4
A look at current interest rates environment
Fed turns hawkish as it steps back from the word ‘transitory’
▪ Federal Reserve Chair Jerome Powell signaled that inflation is now
enemy No. 1 to keeping the U.S. economic expansion on track and
returning the labor market to something approaching ebullient pre-
pandemic levels.
▪ The U.S. central bank said that it would accelerate the tapering of its
bond purchases, scaling back by $30 billion a month rather than the
$15 billion pace it announced just last month. That moves the end date
to March instead of June, opening up the possibility that policy makers
could raise the fed funds rate from its current range of 0% to 0.25% as
soon as the first half of 2022.
▪ The shift by the Fed comes after months in which Powell had insisted
that the rise in inflation was “transitory” and driven by supply-chain
bottlenecks that would fade with time. On December 15, the Fed drove
a stake in the transitory rhetoric, dropping it completely from its post-
meeting statement.
▪ While the Fed statement referenced the risk to the economy from new
Covid-19 variants, Powell played down the potential impact of
omicron, arguing that growth was strong, and that vaccinated
Americans were learning to live with the virus.
▪ Powell maintained that the U.S. could well reach maximum
employment next year when policy makers are projecting that they will
start lifting interest rates from zero. Unemployment has fallen rapidly,
though at 4.2% for November it is still above the 3.5% mark prior to the
pandemic.
▪ He acknowledged that the labor market may not fully return to the
stellar levels that prevailed before Covid-19 struck, particularly when it
comes to workforce participation. Some Americans probably have
dropped out of the labor force for good, including aging baby boomers
whose retirement savings plans have benefited from a surging stock
market.
Data source: Bloomberg
5Historical perspective
Treasury yields slip as market doubts Fed’s decision
▪ Long-term yields have come down as traders priced in the start of what
they see as a quick-yet-shallow cycle of Fed rate increases. The gap
between 5- and 30-year yields has plunged on the December 17 to 63
basis points from a multi-year high of 167 basis points in February.
▪ Investor demand at the Treasury’s 3 and 6-month bills auction was
tepid on December 20, despite the supply boost after the debt-ceiling
resolution.
▪ U.S. yields declined across curve amid concerns omicron spread is
leading to activity restrictions. Treasuries fall was also supported by the
U.S. Senate’s Manchin’s opposition of Biden’s $2 trillion spending bill.
Interest rates monitor: statistics (January 2000 – December 2021)
10yr IRS 5yr IRS 2yr IRS
Historical
Average 3.499 2.920 2.277
Max 7.871 7.795 7.666
Min 0.506 0.243 0.179
Current 1.4400 1.2371 0.8524
From Average -2.059 -1.682 -1.425
From Max
D
-6.431 -6.558 -6.814
From Min 0.934 0.994 0.674
6m $Libor 3m $Libor
Historical
Average 2.043 1.910
Max 7.109 6.869
Min 0.147 0.114
Current 0.3128 0.2126
From Average -1.731 -1.698
From Max
D
-6.796 -6.656
From Min 0.166 0.099
Data source: Bloomberg
6Market forecast
All forecast updated as of 21 December 2021 Data source: Bloomberg
7Main Economic Indicators
8Economic activity: Consumers and Business
GDP growth at its highest in decades
▪ U.S. economy for 2021 is projected to grow by almost 5.5% after the
delta strain weighed on 3Q performance. Consumption powers growth,
bolstered by accumulated household savings and pent-up demand.
▪ Biden is now positioned to surpass Carter (5.01%) as the GDP
champion of presidents since 1976. Much of the credit goes to The
American Rescue Plan, which poured $66 billion into 36 million
households and reduced the child poverty rate by 50%, helping the U.S.
recover faster from the pandemic than most other nations
▪ However, recent events including the emergence of the omicron
variant, and Senator Joe Manchin’s rejection of the $2 trillion tax-and-
spending plan that is the heart of President Joe Biden’s economic
agenda is expected to limit growth in the upcoming period.
ISM services expand, constraints begin to ease
▪ U.S. service providers expanded at a record pace in November as
steadfast consumer demand drove a further strengthening in business
activity and kept orders firm. The index advanced to 69.1 last month
from 66.7 in October.
▪ Bolstered by rapid wage gains and a stockpile of savings, Americans
have the desire and the wherewithal to spend on services. ISM’s gauge
of business activity advanced to a fresh record as the new orders index
held at a record high in data back to 1997. Similar developments
emerged with the ISM’s manufacturing survey. Sustained relief from
capacity constraints across all industries could help to cool still-
rampant inflation pressures.
▪ All 18 services industries reported growth last month, led by real
estate, transportation and warehousing, and retail trade. While these
demand-based gauges continued to show faster growth, other
measures hinted supply constraints may be starting to ease. However,
the group’s index of supplier delivery times held at the second-highest
on record, indicating delays are still well-extended. Data source: Bloomberg
9Labor market
U.S. jobs disappoints despite continued to increase
▪ Nonfarm payrolls climbed 210,000 in November while the
unemployment rate fell by more than forecast to 4.2%. Fed Chair
Jerome Powell said that there is still room for progress in both absolute
levels of employment as well as participation.
▪ Employment in leisure and hospitality posted a small gain after large
increases earlier in the year. Health care job growth was little changed
overall, while nursing and residential care facilities continued to lead
the decline in the industry’s employment throughout the pandemic.
▪ The drop in the unemployment rate and the rise in labor force
participation could help maintain the Fed decision regarding tightening
its policy as inflation proved more persistent previously thought.
▪ Job growth could be further restricted if the recent emergence of the
omicron variant of the coronavirus leads to new restrictions and keeps
people from looking for work.
Data source: Bloomberg
10Inflation outlook
Consumer inflation increases at its fastest annual pace since 1982
▪ U.S. consumer prices rose last month at 6.8% from November 2020,
the fastest annual pace in nearly 40 years, magnifying how rapid and
persistent inflation is eroding paychecks. That’s the highest prices most
Americans have ever seen.
▪ The inflation reading was able to successfully cement the Federal
Reserve’s hawkish turn to tighten monetary policy. Fed Chair Jerome
Powell has confirmed that a faster reduction will take place, while also
saying it was time to retire the description of price pressures as
“transitory.”
▪ Excluding the volatile food and energy components, so-called core
prices rose 0.5% from October. The core CPI was up 4.9% from a year
earlier, a fresh 30-year high. Shelter costs -- which are considered a
more structural component of the CPI and make up about a third of the
overall index -- rose 0.5% in November from a month earlier.
▪ This really jumps out as being problematic from the Fed’s standpoint.
While big gains in autos and energy can be seen to be related in part to
supply issues, and hotels and airfares tied to reopening, housing costs
are more likely to be sticky.
▪ The data also serves as an indication of how rising inflation
and diminishing real wages are weighing on American consumer
spending during a typically strong period for retailers powered by
holiday gift-buying. The results are not encouraging. On an inflation-
adjusted basis, taking into account CPI data, retail sales growth is
actually negative.
Data source: Bloomberg
11Asset prices and the wealth effect
US equity under pressure as omicron and Fed decision weigh
▪ Stocks suffered their worst back-to-back rout since October 2020 as
Jerome Powell reiterated his pivot to inflation vigilance and the
omicron variant continued to spread. U.S. equities later rebounded as
investors took comfort in reports that cases of the omicron variant
have been relatively mild. On December 8, S&P 500 secured its biggest
three-day rally of the year.
▪ Following the Federal Reserve’s final meeting of the year, technology
companies drove stocks down on speculation that rate hikes will
reduce the appeal of the highly valued industry that has powered the
bull market in equities.
Housing starts rise as demand persists despite constraints Daily data – Base = 100 on 1 January 2013
▪ U.S. home construction starts strengthened in November to the fastest
pace in eight months, suggesting builders are making a bit more
headway on backlogs even as supply and labor constraints linger.
▪ Residential starts rose 11.8% last month to a 1.68 million annualized
rate, according to government data released. Meanwhile, applications
to build, a proxy for future construction, climbed to an annualized 1.71
million units in November.
▪ Single-family starts increased 11.3% in November to an annualized
pace of 1.17 million units, also the strongest since March. Multifamily
starts -- which tend to be volatile and include apartment buildings and
condominiums -- jumped almost 13% to a 506,000 rate, the fastest
since February of last year.
▪ Demand for new properties -- fueled by low mortgage rates, a dearth
of options in the resale market, and a pandemic-era desire for more
space -- has held firm despite exorbitant prices. Still, supply chain
delays and labor shortages have driven up costs and hampered
developers’ ability to break ground on new projects.
Data source: Bloomberg
12Beyond the headlines…
Expectations for 2022 GDP growth has been lowered due to ISM services report showed that all 18 industries have seen
the surge of cases linked to the omicron, and Senator growth during the period. Consumer demand is at a high-level
Manchin’s rejection of Biden’s $2 trillion spending plan. despite supply constraints.
U.S. hiring missed forecast, creating fewer jobs than expected. Inflation continues to persist and is currently rising at its fastest
This can be a sign that market recovery was already faltering pace since 1982. The Fed has stopped referring to inflation as
even before the first omicron case was detected in the country. merely transitory.
Stock market fell after the Fed meeting with technology Both single-family and multi-family housing starts as well as
companies being the hardest hit. Omicron worries remain as building permits have climbed despite supply chain delays and
the variant now account for almost 70% of all U.S. covid cases. labor shortages.
The rise of omicron cases in the U.S. and the resistance Overall positive economic data and the high inflation reading
against Biden’s spending plan is slowing recovery specially as may require the Fed to go along with its new plan of faster
economic growth remains sensitive. tapering and raising interest rates in 2022.
What is your view?
13Interest Rate Hedging
14Hedging – Vanilla Interest Rate Swap
Description Indicative Terms*
Initial Notional of USD 100mn,
▪ An IRS is a highly liquid and very wide-spread derivative instrument Notional
Equally amortizing over the tenor
used as the basic tool to hedge interest rate risk.
▪ It is an agreement between two parties to exchange periodic Start Date Spot
interest payments based on a fixed interest rate against payments
based on a floating interest rate (e.g.: 3m $Libor), calculated on a Tenor (alternatives) 5 years 7 years 10 years
notional amount and for a specified tenor.
Fixed rate paid 1.07% 1.19% 1.31%
▪ If coupled with a floating rate loan, the IRS eliminates the exposure
to rising interest rate payments by creating a “synthetic” fixed Floating rate received 3m $Libor, quarterly reset
interest rate loan.
Payments Quarterly, act/360
Main features / drawbacks
✓ Absolute certainty over future cash flows, supporting budgeting
and planning exercise and easy accounting treatment (hedge
accounting – no impact on P&L under certain assumptions).
✓ Flexibility over the loan amount (also with an amortizing profile)
and tenor to be hedged, allowing for partial notional and shorter
tenor than the full one.
✓ Can be structured in a fully Islamic format.
The borrower cannot benefit if Libor drops as they have locked in a
fixed rate through the IRS.
Should Libor rise less than current market expectations (forward
rates), the overall cumulative carry would be negative.
*The levels shown are mid-market levels and do not include any credit and liquidity related charges 15Hedging – Forward-start Interest Rate Swap
Description Indicative Terms*
Initial Notional of USD 100mn,
▪ While an IRS allows borrowers to eliminate their risk and avoid Notional
Equally amortizing over the tenor
unwanted fluctuations in their interest payments, client can
further reduce fixed rate to be paid by using a forward-start IRS – Start Date 1 year 2 years
due to current shape of rates forward curve.
▪ For example, in a 1yr forward-start IRS the deal is concluded Tenor (alternatives) 4 years 6 years 3 years 5 years
(hence, the rate is fixed) on the Trade Date, but the exchange of
Fixed rate paid 1.40% 1.45% 1.53% 1.55%
flows starts in one year (Start Date).
▪ Hence, between Trade Date and Start Date – if the borrower hold a Floating rate received 3m $Libor, quarterly reset
view that rates will go further down before rising up in future –
then they can still benefit from the low Libor. Payments Quarterly, act/360
Main features / drawbacks (compared to a vanilla IRS)
✓ Client can benefit from short term rates remaining low for 1y or 2y
and at the same time can be hedged for any rise in rates
thereafter.
The client achieves a slight negative carry initially. The initial
difference between the floating rate received and the fixed rate
paid is negative – this is offset by later positive cash-flows.
Client in unhedged for the period between Trade Date and Start
Date of the forward IRS.
*The levels shown are mid-market levels and do not include any credit and liquidity related charges 16Hedging – Interest Rate Collar
Description Indicative Terms*
Notional Equally amortizing over the tenor
▪ An Interest Rate Collar is an option on a reference interest rate
that would give the buyer a best case and worst case rate. Start Date Spot
▪ As a hedging tool, it works to protect a floating rate borrower
(Collar buyer) should the reference interest rate (e.g.: 3m $Libor) Tenor (alternatives) 5 years 7 years
rise above a certain threshold (Cap Strike) but should the reference
interest rate (e.g. 3m $Libor) fall below a certain level (Floor Strike) Cap Strike (alternatives) 2.95% 2.84%
client has a minimum rate to pay.
Floor Strike (alternatives) 0.50% 0.60%
▪ An Interest Rate Collar combines buying a Cap and selling a Floor,
the sale of the floor allows the borrower to reduce the cost of the Underlying Index 3m $Libor, quarterly reset
hedge while still allowing him to benefit from lower Interest Rates
up to a certain level. Payments Quarterly, act/360
Main features / drawbacks (compared to a vanilla IRS)
✓ Full protection above the Cap Strike, with the possibility to benefit
should Libor fall up to the floor level.
✓ Worst-case scenario and Best-case scenario is known at inception.
✓ Current market environment (flat to negative yield curve) allows
Collar levels to be attractive
✓ No cash flow if markets remain between the cap and floor
If Markets fall below floor, client will pay the floor which at the
time will be above market levels, yet still it is lower than the
current vanilla swap.
*The levels shown are mid-market levels and do not include any credit and liquidity related charges 17Disclaimer and contact details
Bahrain Treasury Sales
Sameh Baqer Sami Rafia
+973 17585823 +973 17585822
Sameh.Baqer@ahliunited.com Sami.Rafia@ahliunited.com
Sidharth Dubey Lujain AlSaibai
+973 17567105 +973 17585823
Sidharth.Dubey@ahliunited.com Lujain.Saibai@ahliunited.com
DISCLAIMER
This document has been prepared and issued by Ahli United Bank B.S.C. (“AUB”) which is regulated by the Central Bank of Bahrain.
All recipients of this document should note that it is being furnished to them solely for information purposes and may not be reproduced or redistributed
to any other person without the permission of AUB.
Although information has been obtained from and is based upon sources believed to be reliable, AUB does not warrant its accuracy and it may be
incomplete or condensed.
All opinions and estimates constitute AUB’s judgment at the date of publication and are subject to change without notice.
AUB does not advise as to the suitability or otherwise of this information and provides the information to recipients exclusively on the basis that they
have sufficient knowledge, experience and / or professional financial, legal, tax and other advice to make an independent assessment thereof.
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