Corporates scramble to batten down hatches as inflation hits 40-year high

If there was any lingering doubt amongst treasurers that inflation is back with a vengeance then last week’s half point hike by the US Fed – its biggest in two decades — and the Bank of England’s gloomy warning that UK inflation could peak above 10% later this year will have surely erased them.

For many treasurers the current cycle of galloping inflation – it’s running at a four decade high of 8.5% in the US – and associated interest rate risks is, after decades of relatively benign state of affairs on both these fronts, cause for considerable concern. Treasurers know, for instance, that rising inflation has the potential to seriously undermine critical operations such as FX and interest rate risk management.

For Garima Thakur, treasurer at US-based Creative Artists Agency (CAA), the return of inflation heaps further pressure on treasurers battling several other major challenges, including supply chain disruption (itself a driver of inflation) and market volatility. She foresees, however, that the extent of inflationary pressure will vary across companies, with service-based firms generally less directly impacted than manufacturing. Manufacturers will mostly pass the increase in their costs to consumers but that will likely dampen consumer spending which in turn would impact companies in the consumer products and services space.

While the overall impact of inflation will vary across sectors, all companies will feel its impact in certain areas like travel and expense (T&E) costs, according to Thakur.

“Most companies used T&E as a lever during Covid, cutting back on it. It has started to ramp back up though as business travel is restarting so this is a line item to watch.”

More broadly, good housekeeping and redefining and reassessing risk policies in light of the inflationary environment are essential, she says.

“As treasurers we all need to be proactive – not always easy when constantly firefighting as we have been for over two years. Yet we know taking action early works. Companies that strategically managed inventory positions and working capital during Covid, for example, have benefited greatly in profitability despite supply chain challenges and they are in a good position despite inflationary pressure.”

Treasurers should remain focused on strategic working capital management, she notes, particularly in low margin manufacturing and distribution businesses where working capital and supply chain management can be meaningful liquidity management tools.

Central banks in a bind

On the rate policy front, Thakur believes treasurers in the US are keeping a close eye on the Fed following its recent 50 basis point (bps) hike to a target range of 0.75 – 1%. The expectation is the Fed will follow up with another 50bps in June. More rate rises are expected, with the Economist Intelligence Unit predicting the Fed will raise rates seven times in 2022, reaching 2.9% in early 2023.

Hot on the heels of the Fed’s latest hike, the Bank of England followed up with a quarter point increase to 1%, its fourth since December. It amounts to the fastest pace of policy tightening in 25 years.  The BoE warned of further rate rises and warned the UK will experience double digit inflation for the first time in 40 years. The market now sees UK rates rising to 2.5% by middle of next year.

“For central banks globally the big challenge now is to manage rate hikes and inflation while avoiding a recession,” says Thakur. “For companies, rate hikes will of course increase the cost of borrowing for floating rate debt.

“For companies that have interest rate hedges outstanding, the increase in cost of borrowing will be muted. The other side of the coin of higher rate is the incremental interest income that could accrue to provide companies with meaningful excess cash balances to invest.”

The cost of inflation

A study published earlier this month by law firm Herbert Smith Freehills provides evidence of treasurers eying inflation warily. Based on a survey and interviews with finance and treasury professionals in over 80 large UK corporates (mainly FTSE 100 and FTSE 250) between January and March this year, the firm’s annual Corporate Debt and Treasury Report 2022 shows respondents seeing rising inflation playing a greater role in their decision making over 2022.

Biggest inflation challenges as viewed by treasury and finance professionals

The study reveals that while the number of respondents expecting to make use of interest rate hedging over remained static for 2022 versus 2021, the number of corporates not planning to use interest rate hedges in the year ahead dropped by 20% (38% in 2021 to 18% in 2022).

“This increase in usage reflects long running market expectations around central bank rate increases, particularly as major increases in inflation rates in many advanced economies are likely to lead to interest rate volatility,” the report says.

“Respondents noted a need to lock in rates now in advance of the anticipated increases in the rate cycle, as well as the continued need to manage interest rate risk across the debt lifecycle as facilities are extended and refinanced.”

The report also notes that some respondents expressed concern that with low interest rates having been entrenched for over a decade now, some treasury teams and sell-side teams might not have the necessary experience to be able to manage rate risks decisively and proactively and would require support in doing so.

Fintech eyes FX opportunities

Fintechs have been quick to spot the opportunity to offer services that can help address treasurers’ concerns overs inflation. Eric Huttman, CEO of FX platform MillTechFX, says that as inflation leads to increased operating costs, firms are rethinking their traditional processes and relationships in search of savings.

With firms looking to contain costs in an inflationary environment, Huttman believes their treasurers and finance teams could do worse than starting with the cost that is easiest to tackle: FX transaction costs. Corporates continue to overpay for their FX requirements, he says, with the market “frustratingly opaque and often unfair”.

Huttman believes the first problem with the $6.6trn FX market is the lack of transparency, especially when it comes to pricing. In addition, unless they are very large, corporates can have limited choice on which and how many counterparties they trade with.

“Companies tend to work with only a small number of banks for their FX because of the operational complexity of setting up multiple banking relationships. This makes it harder for them to compare prices in the market because they have fewer access points and a smaller number of liquidity providers,” he says.

Unfair FX practices

Another big problem is that brokers and banks give different rates for different clients depending on the type of client that they are. The most competitive rates (those with the lowest spreads) are typically reserved for those with the largest trading volumes.

This ostensibly unfair practice is not a secret, with Huttman pointing to a 2019 report by the European Central Bank that highlights how banks were overcharging smaller corporate customers for FX services with hedging rates by as much as 25 times higher than for their larger and more sophisticated clients.

“The lack of transparency, limited number of counterparties and discriminatory pricing all increases the difficulty for corporates to achieve best execution,” he says.

Fintechs like MillTechFX believe they offer fairer alternatives to the traditional single bank-based FX approach on which so many firms currently rely. MillTechFX itself says it aims is provide fund managers and corporate treasurers with an “independent, comparative multi-bank FX marketplace which reduces FX execution costs and operational burdens”.

“By looking beyond their traditional brokerage or banking relationships, businesses can get access to the kind of liquidity normally reserved for the largest trading institutions, along with associated cost savings, plus the transparency to prove it,” adds Huttman. “By choosing a partner which offers a level playing field for FX, firms will make sizeable savings at a time when cutting costs is critical.”