Managing Your Liquidity in a Rising Rate Environment

Nearly every major economy hit the brakes in 2022. Over the past five decades, monetary policy has never tilted so overwhelmingly toward rate increases as it has this year. The Federal Reserve and the Bank of Canada have raised interest rates six times this year, citing persistent inflation. We expect this trend to continue into early 2023.

How you manage your liquidity during this time is vital. For many businesses, rising interest rates and interest market volatility are making it more difficult to maximize liquidity, minimize operational risk, achieve optimal returns and secure palatable borrowing costs.

To help put things into perspective, Johanna Skoog, Managing Director, Head of U.S. Treasury and Payments Solutions, BMO Capital Markets recently moderated a discussion with two experts who provided their insights on the economy and liquidity management:

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  Jennifer Lee, BMO Capital Markets Senior Economist, is known for her analysis on the U.S. economy, as well as on financial markets and economic activity in Europe and Japan.

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  Benjamin Lambert, Managing Director and Head of Liquidity Solutions, BMO Capital Markets, has deep expertise in partnering with clients to deliver liquidity solutions across their working capital reserves and strategic cash.

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Following is a summary of the conversation.

Lee began with a bit of good news. After four consecutive rate hikes of 75 basis points, central banks are no longer using the term “front loading”—that is, implementing a series of large rate hikes over a fairly short period. In this case, 3 percentage points in just over six months. She quickly noted, however, that we’re not done with rates hikes and that rates will remain elevated for some time.

"In the U.S. we're probably going to be living with a fed funds rate in the range of 4.75% to 5% for about a year or so,” Lee said. “The reason behind that is because the U.S. economy, even after 375 basis points of rate hikes, remains very, very resilient.”

Along with stronger-than-expected third-quarter U.S. GDP results and gains in consumer spending, the continued tight labor market has made this a mild recession so far. According to the October Job Openings and Labor Turnover Survey, there are nearly two job openings for almost every unemployed worker. Canada, meanwhile, reached a record of nearly 1 million job vacancies in the second quarter of 2022. "Until that lets up, we will probably continue to see pressure on wages,” Lee said. “And that, in turn, would need upward pressure on inflation.”

Lee said that BMO expects U.S. real GDP to grow at an annual rate of 1.9% in 2022. She added that BMO has raised its forecast for Canada’s GDP growth rate to 3.5% from 3.3%. BMO expects both countries to experience a downturn in the first half of 2023 followed by a modest recovery in the second half, resulting in net zero growth. Both the U.S. and Canada should rebound to about 1.5% growth in 2024, Lee said.

What does all this mean for North American central banks? BMO expects the Fed to raise rates an additional 100 bps over the next three meetings—50 bps in December and another 25 bps in both February and March—which will result in a fed funds rate in the 4.75% to 5% range. As for the Bank of Canada, Lee said BMO expects two more rate hikes by January totaling 75 bps.

“Remember that a slower pace of rate hikes does not mean cutting,” Lee said. “This means 50 bps instead of 75, or 25 instead of 50. But if you get weaker economic growth, if you get weaker job growth and less spending, that will help with the decision to slow [rate hikes] down a bit. That's what makes this whole situation so unique: bad news is good, good news is bad, and unfortunately that's the way of the world these days.”

Businesses are trying to make sense of the topsy-turvy conditions that Lee described. It’s led to a lot of caution and uncertainty, as well as what Lambert described as “rate hike fatigue.”

"On the one hand, we have clients analyzing all the economic data, the Fed talking points and juggling between the dovish and hawkish comments that come in day after day,” Lambert said. “On the other hand, we have clients that are still trying to make sense of all this and still don't know what to do with their cash.”

Lambert said this is the time to return to the fundamentals of reviewing liquidity management strategies. “We need to go back to the old practice of analyzing cash flows, where cash flow is coming from and where they need to go.”

That means separating cash into three buckets:

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  Operating cash. Your day-to-day working capital cash with immediate access for payments, payroll, etc.

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  Reserve cash. Funds used for regularly occurring future payments in a one- to six-month timeframe, such as for property taxes, dividend payments, debt repayments and bonuses.

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  Strategic cash. Long term cash (beyond six months) that is seldom used. These are the funds set aside for major events such as acquisitions or large capital expenditures.

During the previous low interest rate environment, companies didn’t need to apply this discipline as much. “Why put cash to work when the rates are close to zero?” Lambert said. “Now that the environment has shifted and there's value to capture, we need to go back to this practice and reallocate cash across the different buckets to identify which class could be put to work, and which cash needs to stay overnight to keep the daily liquidity funding.”

Lambert also pointed out the importance of being flexible enough to adjust your investment policy when necessary. “The message is to stay nimble, to go after value, and to fit that value against your liquidity needs, your yield appetite and your risk appetite,” he said.