Summary
• Barclays’ economists expect the base rate to rise to 3.5% by the end of 2016.
• The last rise in the UK base rate was in July 2007.
• Current fixed rates are significantly more expensive than base.
• A number of borrowers have taken advantage of capped tracker loans.

Forecasting is far from an exact science but the exceptional economic events of 2011 have made predicting what the future might hold even more challenging for timber traders.

Interest rates remain near historic lows and inflation well above the Bank of England’s target rate of 2%, having peaked at 5.2% in September. The Bank of England expects CPI inflation to come down at some point in 2012, although exactly when is unclear.

The predicted timing of interest rate rises continues to be pushed out as the strength and timing of any economic recovery suffers from the ongoing deadlock in the Eurozone. Barclays’ own economists expect the base rate to rise from the current low of 0.5% to 1% by the end of 2013 and to 2, 3 and 3.5% by the end of 2014, 2015 and 2016 respectively. But forecasts are just that, and there may be more false dawns before rates tick up, as the unquantifiable impact of the European debt storm continues to rewrite the history books.

Businesses, including the timber trade, have now become accustomed to the low interest rate environment and while firms are increasingly hedging against exposures to foreign exchange rates and commodities, fewer are engaging in interest rate hedging. This change in focus is partly understandable as management teams have not had to worry about a change in the base rate since March 2009 and even then the rate was falling. The last rise in the UK base rate was in July 2007.

Changes ahead

It seems that many timber traders have been lulled into a sense of security around interest rates, which may ultimately prove to be false. It is almost inevitable that rates will rise at some point and businesses should be prepared for a changing monetary landscape. Some may argue that such proactivity is a little premature but it is not uncommon to see farsighted management teams planning three to five years ahead.

You don’t have to go far back in history to see how a similar interest rate environment caught some US corporate treasurers out.

Even before the events of 9/11, the American Federal Reserve’s Open Market Committee (FOMC) had already begun to reduce the Federal Funds rate in the preceding period, reducing it from a high of 6.5% to 3.5% as the US economy began to falter. The Federal Funds rate then continued to fall, bottoming out at 1% in 2003/04 before rising quickly in the space of just two years to 5.25%. Many treasurers had reduced their level of hedging during 2003/04, which left them in an uncomfortable position as rates moved rapidly back up.

The key for the timber industry is to learn from the US experience and to plan for a potential return of interest rate rises in the future. The main issue is that current fixed rates are significantly more expensive than base, which puts a lot of borrowers off doing anything to protect themselves.

Capped tracker loans

We have seen a number of borrowers take advantage of capped tracker loans, which are designed to give borrowers the benefit of some of the positive features of both a floating and a fixed rate – low rates while they last, with the added certainty that they will never pay more than a pre-determined cap.

Rather than a conventional uncapped five-year loan of the base interest rate + 3.5%, a borrower could choose to pay base rate + 4% with the total payable capped at 6.5%, for example. The borrower gets the same rate protection in exchange for a small increase in the loan margin.

For example, if the base rate averages 4% over the period, the borrower with a conventional loan would pay an average coupon of 7.5% whilst the borrower with capped tracker loan would pay 6.5%, a saving of £500,000 over the life of a five-year £10m facility.

Of course, actual savings will differ between businesses but, those that constantly evaluate risks in the widest sense, seek professional advice and access to solutions to combat these risks, will be better placed to navigate the challenging economic environment.