President Trump’s announced tariffs and the resulting flight to quality has pulled swap rates lower by over 15bps and brings the YTD move lower in many parts of the curve to -50bps. While the market’s initial reaction has been to price in a greater likelihood of recession and rates cuts, it remains to be seen how the Fed will respond if inflation data increases with tariffs. The Fed's reaction function remains murky, particularly beyond the end of Chair Powell’s term in 2026. Institutions that remain exposed to rising rates should be cognizant of the countervailing forces at play.
How can institutions exposed to rising rates think about hedging when the next move from the Fed is likely to be a rate cut?
Pay-Fixed Swaps
On the one hand, vanilla pay-fixed swaps continue to be popular with our clients. Lower swap rates give depositories an increased margin of safety- the Fed needs to cut policy rates by over 100 basis points before a 5-year pay-fixed swap becomes an expense. That improved margin of safety has increased the popularity of the strategy in recent weeks.
Combining Floors with Pay-Fixed Swaps
As an alternative to standalone swaps, we recently shared a strategy that combines a pay-fixed swap with an interest rate floor. The initial income on the pay-fixed swap offsets the premium expense on the floor, even when the floor strike is set at the swap rate. As a result, the maximum cost of the structure in lower rates is equal to premium expense on the floor.
Costless Collars
Lastly, pricing on costless collars has also improved on these market moves. Institutions with expected margin expansion in lower rates can buy a cap struck at current SOFR (4.37%) and make the structure costless by selling a floor struck nearly 200bps below the cap strike.
Current Hedge Pricing
Pricing indicative as of 4/3/25, initial carry assumes 4.37% SOFR
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