Waiting for Godot begins with our protagonists Vladimir and Estragon bickering by a tree. Soon Estragon stands up and peruses the barren landscape:
Estragon: Charming spot. Inspiring prospects. Let’s go.
Vladimir: We can’t.
Estragon: Why not?
Vladimir: We’re waiting for Godot.
Just before the end of Act 1 a boy appears. After establishing that the boy works for Mr. Godot, Vladimir finally encourages the boy to deliver his message: “Mr. Godot told me to tell you he won’t come this evening but surely tomorrow.”
Like Vladimir and Estragon, the markets have been waiting; waiting for a rate rise. Chart 1 below illustrates that prolonged and disappointing wait.
The chart shows the market’s expectation of what the yield at the one year tenor on the gilt curve would be 1, 2, 3 and 4 years in the future. In September 2009 the market believed the one year yield would be 1.3% in a year’s time, and 3.2% by September 2011. In fact, the one year yield was 0.6% on both of these dates (not shown). At no point over the last few years has the market been right about short-term rates, yet we still believe the market when it tells us that rates will soon rise.
But perhaps I’m being unfair. Things were different in 2009-2012. The European Sovereign Debt Crisis was raging, the financial system was still susceptible to major tail risks, and we didn’t understand the scale and severity of the challenges facing the global economy. Since then we’ve written-down assets, paid off debts and mended balance sheets across the public and private sectors. The UK economy in particular is displaying a strong recovery: consumer confidence is returning, indicators of activity in the construction, manufacturing and services sectors are all near record highs, and real wage increases are finally positive. We’ve learnt a lot over the last few years, but now that the economy is conclusively recovering, the Bank of England will have to act soon. Surely!
OK, let’s assume that this analysis is correct and that the economy will soon justify a rate increase. A common reaction to that position is that, since interest rates are bound to rise, there’s no point in hedging interest rate exposure now. It will be much cheaper to hedge when rates are higher. Hedging now would just lock-in losses.
Neat, plausible, and wrong. Unfortunately there is a flaw in this argument, and we have mentioned it already. The market expects that rates will increase in the coming years. We know that from the upward-sloping forward curves in Chart 1. But that expectation of higher rates in future has been built into the prices of all interest rate sensitive products today. So even if we know for sure that rates will increase in the coming years, that information alone is insufficient to determine whether hedging rates in future will be cheaper, since the market has already taken it into account.
Chart 2 demonstrates the point. The red line is the market’s expectation of the one year yield, two years previously. The black line is the actual one year yield that transpired.
Anytime the red line is above the black line, you lose out from being underhedged, because you will be discounting your liabilities at a lower rate than you expected. If you had a liability cashflow that was due in September 2012, in 2009 you would have expected to be discounting it at 3.2%. In 2011 you would have actually had to discount it at 0.6%. This represents a significant increase in your liabilities and demonstrates the key point: It doesn’t matter whether rates rise or fall in future, what matters is where rates are relative to your expectation.
If rates are lower than you expected, you lose from being underhedged.
By this admittedly simple metric, being underhedged has been a losing strategy for the last three years. Any time was a good time to hedge, despite the fact that the Bank of England Base Rate has been at a record low throughout the period.
So here we are, like Vladimir and Estragon at the end of Act 1, waiting for our Godot; an interest rate increase. Disappointed that our wait has taken so long and, all the while, suffering marked to market losses, and the drain on our “emotional capital” as interest rates have continued to fall. And worse, at the back of our minds is the thought that, even when interest rates are increased, will it provide the salvation we need? Will it justify the pain and sacrifices that we’ve endured in the process? We waited for Godot, but was it worth it?
Please note that all opinions expressed in this blog are the author’s own and do not constitute financial legal or investment advice. Click here for full disclaimer.