We enter 2025 with a flat swap curve for the first time in years. Swaps are pricing in less than two Fed rate cuts over the next year while the spread between 2-year and 10-year rates is near 0%.
More than a few clients have remarked that in this environment, it's hard to feel conviction about a hedging strategy. We disagree; ambiguity in the curve provides a unique opportunity to hedge against both rising and falling rates. Waiting until a risk is known is to wait until it's too late- markets are efficient, and the cost of hedging can quickly become prohibitive.
While we believe institutions should mitigate risk regardless of curve shape, the reality is that short-term carry plays a significant role in decision making. Hedges with positive carry are invariably more popular than hedges with negative carry. In today's flat curve environment, rising and declining rate strategies can be executed with minimal day one earnings impact, a rarity.
With a flat curve to start 2025, here are three strategies we expect to gain in popularity:
Interest Rate Collars
For asset sensitive depositories, a purchased 3.75% floor can be combined with a sold 5.30% cap to create a collar. The strategy both protects against near-term rate cuts and minimizes expense unless rates rise above previous cycle highs.
Pay-Fixed Swap Unwinds
Some clients have looked to unwind swaps as they look to limit potential downside should rates fall. Interest rate floors are a helpful alternative that limit potential downside while preserving upside rate protection.Read our 2024 summary of the strategy.
Return of Bond Hedging
2024 was a stark reminder that even if the Fed reduces rates, it's possible for the long-end of the curve to climb. To preserve the investment portfolio's role as a source of liquidity some institutions have returned to using forward-starting pay-fixed swaps and other instruments to insulate against losses.
"Derivative Path” refers to affiliates, Derivative Path, Inc. and Derivative Path Hedging Solutions, Inc. Derivative Path, Inc. ("DPI") is incorporated in the State of Delaware, United States, and is headquartered in the State of California.
Derivative Path Hedging Solutions, Inc. ("DPHS") is a member of the National Futures Association (NFA) and is registered as an Introducing Broker (IB) and Commodity Trading Advisor (CTA). This communication is for informational purposes only, is not an offer, solicitation, recommendation or commitment for any transaction or to buy or sell any security or other financial product, and is not intended as investment advice or as a confirmation of any transaction.
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