Using Interest Rate Derivatives in an Inverted Curve Environment

After the Fed began its tightening campaign in 2022, it didn’t take long for the Treasury yield curve to invert, meaning the 2-year Treasury yield is higher than the 10-year Treasury yield. Market participants, the Fed and economists also look at the curve shape between 3-month T-bills and the 10-year. Regardless, when the curve is inverted, it has historically been a strong indicator of an impending recession.

You have probably heard it said, “The Fed always leads us into a recession.” Unfortunately, that is almost always the case, because when the Fed increases its monetary policy rate to slow down economic growth and/or to fight off inflation, they usually overtighten. In turn, growth becomes restrictive, leading to an economic downturn.

When the curve inverts, Interest Rate Derivatives (IRDs) can be used to your advantage after identifying what you would like to hedge.

During the pandemic, financial institutions were putting 15- to 30-year fixed rate mortgages on their books between 2.5%-3.5%. Rates rose so fast in 2022 that many felt like the window to hedge those positions had closed. Well, rates can keep going higher, continuing to drive the market value of those legacy assets lower. In this example, this pool of legacy mortgages will be our hedged item.

Is high or low interest rate risk more concerning?

Owners of mortgage loans/pools need to be mindful of both higher and lower rates. If rates drop, homeowners will prepay their mortgages and finance at a lower rate. If rates rise, homeowners will be happy to stay in their lower rate mortgages. Since these mortgages were put on the books at much lower rates than today’s, lower rates would be welcomed and higher rates would not. Since lower rates would be preferable, let’s assume rates go higher from here and the curve remains inverted.

Using IRDs to hedge these legacy mortgage assets

Since our crystal ball told us rates are going higher, it is time to hedge. We will use IRDs in this example because they are extremely customizable and are often the most cost-effective tool used to hedge IRR exposure.  

Let’s assume “Hedge Credit Union (HCU)” wants Catalyst to review its $25 million pool of 3.5% 30-year legacy mortgages. Catalyst analyzes this pool, breaking down the risk points across the curve. Then, based on the analysis, Catalyst provides the client the primary risk points. In this example, they fell between the 7- to 12-year part of the curve. Therefore, hedging the front end of the curve is not necessary.

Although Catalyst would provide a detailed analysis and plan on optimal hedging strategies, we’ll keep this sample analysis simple. Let’s say that HCU and Catalyst agree to reduce potential IRR at the 7-year point of the curve. Also in the analysis, Catalyst determines it takes $5 million notional on the pay fixed swap to bring the 7-year risk point down to nearly neutral.

Looking to the market to hedge the 7-year point, HCU can enter a $5 million pay fixed 7-year interest rate swap versus SOFR at roughly 3.60%. But if we move forward the start date on the pay fixed swap by two years for a 5-year swap (seven years total), HCU would pay only 3.15%. Not only does that bring the fixed rate cost down by 45 basis points, but also it accomplishes the goal of reducing some of the inherent interest rate risk derived from the legacy mortgage portfolio.  

Make Curve Inversion Work for You

Curve inversion is the reason the 3.60% rate is so low compared to the Fed’s policy rate. The further you go out on the curve, the cheaper the fixed rate you generally pay. Even better, that rate was reduced further to 3.15% by forward starting the hedge by two years. This enabled us to leap over the positive slope out to the one-year point of the curve and take advantage of the lower forward rates out on the curve created by the curve inversion.

A very powerful tool, interest rate derivatives can require careful preparation and research. For a derivatives partner you can trust, contact Catalyst Strategic Solutions today.