Inflation special report


A lack of consensus is generally good for markets - and there is certainly no agreement on the direction of inflation at the moment. With fears of a double-dip recession dominating for much of this year, dealers say they saw strong demand for inflation floors from pension funds and other asset managers, keen to protect themselves against a worst-case scenario of deflation.

This fear led to the biggest options trade of 2010, with Toronto-based insurer Fairfax Financial purchasing zero-coupon 0% floors worth $21.539 billion in notional. But it hasn't all been one-way traffic. High prices for these floors have prompted a growing number of participants to think deflation fears are overplayed. As a result, some have looked to make a quick buck by monetising the zero-coupon 0% floors embedded in their linker portfolios. Pimco was the highest-profile manager to reap the rewards for selling these floors - others have followed suit.

However, inflation expectations appear to be on the cusp of a change. With the Federal Reserve widely expected to recommence quantitative easing, fear of inflation has shot up the agenda once again. Dealers say there has been recent activity around high-strike inflation caps as a result.

This activity is centred at the extremes - either low-strike floors or high-strike caps. Nonetheless, dealers appear to be encouraged about the growing willingness of investors to consider using options to express their views on the future direction of inflation.

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