August 17, 2016
If you are a farmer whose operating loans next year (and beyond) will be tied to either LIBOR (London Interbank Offered Rate) or the Prime Rate, you absolutely should seriously consider this…
I MAINTAIN THAT YOUR BORROWING COSTS ARE GOING TO GETTING PROGRESSIVELY HIGHER OVER THE NEXT FEW YEARS…BY SOMETHING LIKE 2-3 % AT LEAST…WHICH WILL MEAN MONEY OUT OF YOUR POCKET…BUT…YOU CAN, VERY SIMPLY, LOCK IN TODAY’S LOW RATES FOR THE NEXT TWO OR THREE YEARS USING THE EURODOLLAR FUTURES CONTRACT…AND THEREBY AVOID THOSE INCREASED INTEREST RATE COSTS TO YOUR FARMING OPERATION (OR ANY OPERATION THAT WORKS WITH BORROWED MONEY).
I know, from talking to many of you, that you do not really understand what “Eurodollars” actually are, how they work and how they do relate to interest rates and borrowing costs…so hopefully what follows will make it clear to you…
TAKING IT STEP BY STEP…
The first thing I’ll do is give you a loose definition: The Eurodollar Futures Market (which has NOTHING to do with Europe) tracks THE basic international interest rate for 90 day money…when borrowing in Dollars (which is what you do)…anywhere on the planet.
I also know that many of you are familiar with LIBOR…as your loan rates are often based on “LIBOR + ‘X’ percent”… and you therefore are aware that your borrowing costs do rise and fall according to what LIBOR is doing…So the next thing I want you to understand is that LIBOR and the Eurodollar Interest Rate are virtually identical to each other (charts below)…and I do mean IDENTICAL.
And finally…As some of your loans can also be based on a “Prime + ‘X’ percent”, I will point out that the Prime Rate, which is generally several percent higher than LIBOR, also moves up and down in an almost direct correlation to what LIBOR and the 90 Day Eurodollar Rate are doing.
THEREFORE…IN OTHER WORDS, IF LIBOR IS GOING UP…YOUR ANNUAL BORROWING COSTS WILL BE GOING UP AS WELL.
These three charts should help make their ironclad relationship quite clear…
So…How do you hedge against higher borrowing costs?
I know this can easily get confusing so I am going just keep this as brief as I can…just the nuts and bolts…and the numbers.
First up, the size of the Eurodollar Futures contract is for $1,000,000 of 90 Day money…To you, this would mean that if your annual Line of Credit was generally running about a million dollar balance, it would take 4 contracts (one for each quarter, that being, one each in the March, June, Sept & Dec) to cover you for all of next year…And taking it one step further, if your LOC balance is more like $250,000 a year, you could cover all of next year using 1 December, 2017 contract...
And I know that is confusing…so here are some charts with real numbers that should give you a better idea of how the dollars actually work…with the bottom line being that you basically need 1 contract to cover every $250,000 you are normally borrowing.
The first chart is of the Eurodollar Futures market going back to 1983…Two things to understand…
The 100 mark on this chart represents ZERO interest rates. 99 would be a 1% rate, 98 would be 2 % and so on…33 years ago, the Eurodollar rate was at 84, or 16%...and has been ratcheting lower ever since. So, as noted on the chart, WHEN RATES ARE GOING UP, THIS CHART GOES DOWN.
2. A move from 99 to 98, or a 1% increase in rates, ANNUALIZED, would mean a $10,000 increase in interest payments on $1,000,000…BUT…this contract is based on 90 days…a quarter of a year…so ¼ of $10,000 means that each quarter of the year’s interest would be $2500.
And I can easily imagine that you are sitting there going, “What? Don’t get it.”…So let’s go to the chart…
First thing...Note that there have been 5 periods of rising rates since 1983...when rates went up 4%, 5%, 4%, 2% and 6%...And in my opinion, there is no question that we are about to see at least a few years of higher rates...and I think they will go up AT LEAST 2-3%...
There are two ways to go…
With futures, there is the possibility that the Eurodollar market will rise (if rates keep falling), which would potentially mean a margin call…If, for example, you sold at 99.00 and the market rallied to 99.50, you would be down 50 points or $1250 per contract…BUT…your borrowing costs should also have gone down by roughly the same amount…I would also add, and this is just my opinion, that if rates ARE still at current levels, or have gone even lower 9-12 months from now, it would mean the US and World Economies had totally fallen off a cliff…which, if you been reading my newsletter all year (and prior)…you’ll know this is exactly the opposite of what I think is happening now…and going to continue happening. CONTRARY TO WHAT YOU SEE OVER AND OVER IN THE EVER ECONOMICALLY NEGATIVE MEDIA, THE WORLD IS ON THE UPSWING.
Or you can simply buy a put option…
With the put, you will be giving up $786 of any profitable benefits of having the hedge but you also will not need to deal with any potential margin calls…For my money, however, with my very definite expectation that rates WON’T be staying low, I think it makes sense to just go with the futures.
I would also point out that the Eurodollar contracts go out for YEARS…and are extremely liquid (this IS the biggest, most heavily traded futures contract in the world)…and I firmly believe what REALLY makes sense is to hedge borrowing costs all the way out through at least 2018…
Here is the contract you would use to lock in today’s rates all the way through 2018…AMAZINGLY, THE MARKETS HAVE ONLY BUILT IN ABOUT A 1/4 PERCENT INCREASE GOING OUT FOR MORE THAN 2 YEARS…WHICH I THINK IS AN EXCELLENT EXAMPLE OF HOW “STUPID” VALUES DO OFTEN GET IN THE MARKETS…AS I AM FOREVER REMINDING PEOPLE, THE MARKETS…STOCKS, BONDS, COMMODITIES…ARE NOTHING BUT A MASSIVE MOB PSYCHOLOGY GAME…NONE OF THE VALUES OF ALL THESE PIECES OF PAPER WE TRADE ARE REAL…TODAY’S PRICE IN ANY MARKET IS MORE A FUNCTION OF THE LATEST MEDIA PERCEPTIONS…FEAR…GREED…AND THE EVER PRESENT HERD MENTALITY OF THE SPECULATIVE PUBLIC.
Ok…I know that hard as I have tried to make sense here, a lot of this may come off like Greek…But the bottom line is this: YOU CAN USE THE EURODOLLAR CONTRACT TO LOCK INTO TODAY’S RATES GOING OUT FOR OVER TWO YEARS…and I assure you I can clear up any questions or doubts you might have as to how this all works in one conversation…So if you DO think it makes sense to lock down your borrowing costs at today’s levels, if you DO think interest rates will be going higher over the next few years, DO pick up the phone and call me.
When you get down to it, if Soybeans were at $20.00…and you could lock them in at that price for a full two years…wouldn’t you do it?...Well, this is the same thing.
And again, if you have ANY type of borrowing in your future (construction or bridge loans, for example) that will be tied to LIBOR or the Prime Rate, you definitely should be looking into this.
All option prices in this newsletter include all fees and commissions.
The author of this piece currently trades for his own account and has a financial interest in the following derivative products mentioned within: Eurodollars