The widespread belief that the Federal Reserve will at least signal a rate rise even if it doesn't actually hike rates is expected to encourage corporations with outstanding fixed-to-floating interest rate swaps to unwind the trades. Bob Gay, head of fixed income strategy at Commerzbank Securities in New York, explained that given the recent healthy performance of the U.S. economy, interest rates cannot stay at today's low levels. In the interest of a smooth transition, hikes in interest rates are expected to be flagged well in advance. Between this signal, and actual interest rates increases, which may be fragmented, corporations will steadily unwind their positions, he predicted.
Over the past few years corporations have made great reductions in financing costs by converting fixed-rate debt into synthetic floaters, said Gay, explaining corporates may be paying as little as 2% and receiving 4% in many of the swaps. Once rates increase much of the financing advantage will be lost. Gay estimated that rates will go back to some 3-3.5%.
Eric Hiller, chief rates strategist at Bank of America in Chicago, agreed that there is a risk of corporations, including banks, unwinding fixed-to-floating positions over the course of the next year. The steepness of the yield curve gives the positions positive carry that would be lost if the curve flattens, as many fear it will. In spite of this, Hiller thinks the Fed will be more sluggish than the market is predicting.
As demand for unwinding fixed-to-floating positions picks up swap spreads are also expected to widen. Last summer record refinancing of U.S. mortgages caused a huge surge in volumes and gapped out swap spreads (DW, 8/3). Last August spreads were driven out to 70 basis points, compared with 37bps last month. Demand for swap unwinding will likely push spreads back. Hiller estimates that spreads will stand at around 55bps in 12 months.
