01 Nov 2010, BGC Partners , Barclays Capital , BNP Paribas , Citi , Deutsche Bank , HSBC , JP Morgan , Royal Bank of Scotland (RBS) , UBS , Nomura , Risk magazine
Barclays Capital Nikolay Stoyanov, Associate Director, Inflation Derivatives Trading (NY)
BGC Partners D’Arcy Miell, Global Head of Inflation Products
BNP Paribas Keith Price, Head of US Inflation (NY)
Citi Carl Bonde, Inflation Trader (NY)
Deutsche Bank Allan Levin, Head of Inflation, North America (NY)
HSBC John Harrison, Head of USD Inflation (London)
JP Morgan Alvaro Mucida, Executive Director, Head of USD Inflation Trading (NY)
Nomura Michael Anthony, Vice President, USD Inflation Trading (NY)
Royal Bank of Scotland Raj Shah, Inflation Trader (Stamford, CT)
UBS Dariush Mirfendereski, Managing Director, Global Head of Inflation Linked Trading (London)
Risk: What growth in volumes in the US inflation derivatives market has been seen in the last 12 months?
D’Arcy Miell, BGC Partners: Interbank market volumes are up 30%–35% from last year. The options business has grown significantly since the first trades in 2007, with options now accounting for 12.5% of the total volume of trades done in the interbank market. We are also seeing a great deal of interest in US inflation products from a lot more banks. More participants are coming into the market and there is definitely more liquidity being provided.
Risk: How has the overall US inflation market developed over recent years?
Dariush Mirfendereski, UBS: What is most striking about this market is that the underlying Treasury inflation-protected securities (Tips) market is the largest in the world. Yet the derivatives market in the US has always been an underperformer compared to the eurozone and UK markets, which are both actually smaller on the cash bond side. There are good historical reasons for this discrepancy. D’Arcy’s numbers cover most of what the market has done in the broker market. To estimate the total market size, i.e. to include end-user trades, one can typically multiply the broker volumes by three in terms of total volumes. You can see similar numbers in 2004 and 2005, then a dip in 2006. But trading volumes have picked up since and have been gradually growing every year.
The dilemma in the US market is that a lot of people would buy Tips for the inflation protection but they may not because they’re locking in low yields. If there were corporate inflation-linked bonds, i.e. some higher-yielding instruments, they may actually get more involved. In the European market, you get end-users using derivatives as overlays on top of fixed-rate bonds of all types, and therefore achieving those high-yielding instruments. The biggest problem in the US was – and still is – that the cost of trading zero-coupon inflation swaps compared to where Tips are trading tends to be quite high. People refer to that as the ‘richness of the swap market’. The main reason for this richness is that the market has always been driven by one-way demand for inflation swaps with no natural supplier of those swaps to bring prices back down to Tips-implied levels.
The extreme example is in the UK, where you had the natural two-way flow pre-credit crunch, during which period inflation swaps traded on average close to fair value. The US only relied on the route of asset swaps of Tips as a way to get supply sources of inflation swaps. I call the asset-swap route ‘synthetic supply’ – you create supply using an existing instrument. Post-crisis, even the UK market is largely relying on asset-swap synthetic supply.
The term structure of the nominal spreads in each market can have a large influence on the richness of inflation swaps. In the US, the GC-Libor spread pre-credit crunch was around 20 basis points, while the 10-year swap spreads were in the 50–60bp range. To achieve a zero carry position holding Tips asset swaps – i.e. the Libor-plus payments balancing out the funding payments – you would trade Tips as rich as perhaps GC levels, for example, Libor minus 20, but no richer. Although they were still trading cheaper than Treasuries, the trade wasn’t compelling beyond that flat carry level and the hedge fund community collectively settled at trading them at those levels. This pricing embedded a richness of about 30–40bp in the inflation swaps, reflecting the difference between 10-year swaps spreads and the GC-Libor spread. Although the structure of demand met by asset-swap demand was quite similar to the European market, in the latter, you had a relatively flat nominal spread term structure. GC-Libor was about 10bp, 10-year spreads were 15bp or, at most, 20bp. That meant the richness of the swap curve in Europe was only about 5bp or 10bp for the 10-year maturity, which then reduced the barrier to entry for people who wanted to use swaps as overlays. The overall yield you got was good value and you got enhancement from the credit curve.
The next impediment to the growth of the US inflation swap market was the fact there is a lack of familiarity and a general dislike of the word ‘derivatives’ in the US. The events of the past two years haven’t really done much to help that. Nevertheless, as we see the market grow, some of the recent developments, especially on the options side, are really helping because customers can see that you can actually transact in large size. You can see trades of multi-billion print and, therefore, you see the flexibility of using the derivatives side compared to what Tips offers you. Especially interesting in what we have seen in the volumes is how the proportion of options traded has increased over the past few years and we can only see that increasing going forward.
Risk: If asset swaps are so important for the development of the US inflation derivatives market, what else drives the demand for them?
Alvaro Mucida, JP Morgan: To understand the demand for asset swaps, we need to look at the overall state of the market place, in terms of risk appetite versus need for liquidity. When the market is in crisis or risk aversion mode, investors allocate resources in the most liquid assets and avoid alternative types of investment and we see a large drop in demand for asset swaps. When the market normalises and investors seek alternative ways to enhance their yields, we start to see more interest in alternatives like Tips on asset swap. Credit spreads are also a major driver. If credit spreads are wide, that tends to reduce interest in asset swaps in general. Relative levels of asset swaps versus nominals and inflation-linked bonds in other countries are also important factors. A significant part of Tips asset-swap demand comes from foreign investors who have a global perspective and look at several markets at the same time. Cross-currency basis is also important, as we have seen some of these overseas investors overlay a basis swap to get this yield pick-up in their home currencies.
Transaction costs are also a major consideration. Something that may increase transaction costs in asset swaps is the fact that the Street is now looking more closely at the funding implications of their credit support annex with each counterparty. Now banks are looking at discounting the future cash flows at their home funding curve rather than just using the local discounting curve. All of these recent developments have, to a certain extent, generated some difference of opinion among dealers over the right level of asset swaps, which clouds the transparency of the market. Getting back to the need for liquidity, clients like to see transparency; they like to see evidence that they can transact without moving the market too much. Asset-swap buying can help create pockets of liquidity when there is good demand for inflation swaps on the other side. This two-way flow allows banks to transact in a decent size without moving the market too much.
Another factor that influences demand indirectly is the price of the floors. That creates some correlation of asset-swap spreads with breakevens because, as breakevens go up, floor prices go down and the other way around as well. When inflation swap prices go down or demand for deflation protection rises, that increases the price of the embedded floor and consequently the asset-swap spread, which tends to generate more demand for asset swaps.
Risk: How has the US inflation options market developed over recent years?
Allan Levin, Deutsche Bank: Before talking about recent developments in the inflation options market, let me give a brief introduction to the two main types of options that trade most frequently. First, we have year-on-year inflation options that typically pay out annually. For example, a five-year year-on-year cap with a strike of 3% would pay each year any excess of that year’s inflation rate over the 3% strike. Year-on-year caps and floors are often embedded into inflation-linked notes issued by dealers, mainly into the retail market. The second type of option is the zero-coupon option. These make a single payment on the maturity date. For example, a 10-year 0%-strike zero-coupon floor would only pay out if inflation has been cumulatively negative over a 10-year period. In terms of upfront premium, the zero-coupon options tend to be cheaper than year-on-year options as they are less sensitive to spikes in the level of inflation, as deflation in one year may be offset by high inflation in another year, resulting in a reduced payout on maturity. The 0%-strike zero-coupon floors with five-year and 10-year maturities are especially liquid as they are almost identical to the redemption floors built into on-the-run Tips.
In terms of recent developments in the market, the growth in the past year has been astounding. This has been driven by divergent views on the likely course of inflation and concerns about tail risk, with respect to both deflation and elevated levels of inflation. At the end of last year and for most of this year there has especially been large-size trading in 10-year deflation floors. Recent press articles have highlighted some of the participants that have been involved, as well as the rationale behind the trades.
It was reported recently by The Wall Street Journal that a North American insurer had bought in the region of $22 billion of deflation floors. The rationale behind the trade was actually quite interesting. The insurer was naturally long equities and corporate bonds. Accordingly, as long as the economy recovered well, they would do well as an institution. However, they also gave consideration to their worst-case scenario. The insurer was very concerned that a Japan-style recession and corresponding deflationary scenario could happen in the US. They needed an insurance policy on the economy to offset corresponding losses on their equity and corporate bond portfolios. The zero-cost deflation floors were viewed as a very cheap way to hedge this particular tail risk. Essentially, it would give them an instrument that would pay out when they would most need the money.
On the other hand, it was reported that a large US asset manager, Pimco, had sold billions of dollars of the same option. It was interesting to note that Pimco’s rationale was quite different because they were in a very dissimilar situation. Pimco was naturally long these options by virtue of being a large holder in Tips. As Tips have these options embedded, Pimco was in the position to sell these options on a covered basis. This opportunity allowed them to monetise the value of the embedded options.
The large trading that we had seen in zero-coupon options had two major implications for the market. First of all, it has generated a great degree of relative-value trading. For example, participants taking views on five-year versus 10-year options, taking views on year-on-year options versus zero-coupon options, etc., has resulted in improved liquidity throughout the option market. Perhaps even more relevant is that the recent press on these options has triggered a significant amount of interest from new clients. We’ve seen many new participants familiarise themselves with and begin to trade these instruments.
More recently, there has been a noticeable shift in focus from fears of deflation to that of hyperinflation, given the potential for additional quantitative easing; for example, there has been investor interest in selling floors and using the proceeds to buy inflation caps.
As an active participant in the inflation options market, it has been very exciting to be involved in the development of this market. We anticipate that the rapid growth will continue for some time.
Risk: How might forthcoming developments in accounting and regulation impact the market?
Michael Anthony, Nomura: It is something that is going to have a substantial impact on the market for the foreseeable future. There are two main potential items of regulation that will ultimately be a good thing for our market, the larger of which is the discussion centred on central clearing for derivatives. Particular to the inflation derivatives space, the largest impact is the mismatch in seasonals amongst various different banks and the assumptions made. If we move to a central clearing-system mechanism, collateral will be posted daily and we’ll all have different valuations feeding into the same system. In reality, we need to have a centralised number that is consistent among all of us. The question is, do we move to something similar to a London clearing house-style mechanism whereby the central clearing house takes various types of collateral?
This brings the next question of what types of collateral will we be allowed to post and the impact of that on the discounting methods that we all use ultimately on these derivatives themselves. It is often thought that cash-only collateral is the easiest mechanism for various different discounting methods, which will ultimately be discounted back at the overnight rates. However, if Tips were eligible collateral, then that raises a new discussion on whether or not Tips asset swaps should be the discounting method or, ultimately, whatever the most difficult repo or collateral would be at that clearing house.
The second thing I want to talk about is pension reform and the potential for that in the US to move towards what we see in the UK. Obviously we are entering a very low rate environment where we have defined benefit pensions that have a fixed percentage of payout associated with historic return. Ultimately, I think that there will be another reform that would potentially suggest something like the UK mechanism, which is inflation plus some kind of return. That could potentially cause our market to look like the UK market on an ongoing basis and, ultimately, cause the derivatives market to grow substantially.
Risk: What about the role of seasonality and other risks?
Nikolay Stoyanov, Barclays Capital: Seasonality had not been fully appreciated in the inflation market until a couple of years ago, both in the case of the derivatives and the cash markets. Most of the cash bonds have January or July maturity dates. July maturity dates happen to enjoy consumer price indexes (CPIs) that are on a seasonal basis, higher than the January. So, in the Tips market, until a couple of years ago, you could – even with moderate correction for seasonality – find mispricings on the curve. The derivatives market also did not incorporate seasonality quite as much. Then the Treasury started issuing April notes with five-year maturities. In fairness, there are three long-dated April issues, with maturities in years 2028, 2029 and 2032, but the seasonality impact in terms of basis points is small for such long maturities. So now we have a few points – we have April, July and January points – so the market started appreciating the differences and has started pricing it in the Tips market, as well as the derivatives market. However, there is also the complexity of the embedded floor options, which are more valuable for the April issues that enjoy higher base CPI than the corresponding January or July issues around the same maturities. This difference in the optionality value complicates the deduction of the implied seasonal factors. The derivatives market has the additional difficulty in that you would have to map out the full seasonality curve for any other month that is not mapped out by the Tips market.
Based on past market behaviour, there seems to be a significant disparity in terms of how different participants value seasonality. In terms of estimating seasonality from past data, there are a few econometric techniques out there to do that. One can use a parametric approach, which basically fits a smooth parametric curve to the data to describe the trend and then picks out and averages the residuals for each corresponding month. The non-parametric approach, which is probably the more favoured, uses a form of a moving average to smooth out the series and the residuals of each month to the trend are used to calculate the seasonal factors. There are complications, however. When you have a one-time event, Hurricane Katrina being the most notable recent example, then the econometric estimation becomes more difficult. In fact, the Bureau of Labor Statistics revised their own seasonality estimates a couple of years back when they decided to correct for the Katrina effect. I suspect a more developed CPI fixing market would bring into line the seasonality estimates between different dealers in the market.
Another risk associated with managing inflation-linked derivatives portfolios is the CPI fixing risk. The most liquid inflation swap is the zero-coupon inflation swap, which basically amounts to a single payment at maturity and is affected a lot by the last couple of prints prior to the maturity. This short-term fixing risk has become more significant as many of the original trades done as five-year to 10-year swaps, being still the most liquid and traded portion of the curve, come close to maturity. One of the ways people have tried to manage this risk is by trading energy futures, which to some extent correlates with the energy components of the CPI number but, overall, the rest of the components remain largely unhedged.
The other risk I want to talk about is the year-on-year swaps versus the zero-coupon inflation swaps. Year-on-year swaps used to be more popular when there was larger issuance of inflation-linked notes, which in their most common form pay year-on-year inflation, but, as the corporate issuance subsided in 2004/2005, so did the interest in year-on-year swaps. Nevertheless, there is a significant number of those swaps still on the books. Zero coupon swaps are model-independent. However, in the case of year-on-year swaps, because both start and end CPI values are set in the future, there is model dependency, and the convexity correction depends on correlation factors that are quite hard to estimate.
The last thing I want to talk about is the options market. The options market is still relatively illiquid. It is very difficult to price and hedge options that are with off-market strikes. Now we talk about the liquidity of the zero-coupon inflation options, but most of the trading is really done around the 0% strike floor, because the latter is essentially embedded and derived from the most recent Tips issues. However, managing options with other strikes or maturities is a bit more difficult.
Risk: We talked about asset swaps earlier. Do you have any thoughts on the current level of asset swaps and whether that is particularly compelling?
John Harrison, HSBC: I think the answer is yes, but it depends on who you are. Since the crisis, we have seen a significant tightening of asset-swaps and are now closer to pre-crisis levels. So, for speculative accounts looking for a quick mark-to-market (MtM) gain, the major move has already occurred and no longer looks compelling. But, for accounts who are looking to invest cash or hold the highest-grade collateral, Tips on asset swap still represent a compelling trade.
For example, for corporate treasurers and central banks who are cash-rich and risk-averse, selling agency and AAA rated non-government paper to buy Tips asset swaps to pick up 35bp seems like an obvious trade. Another example would be for financial institutions who are under pressure from regulators to increase their holdings of liquid assets to hold Tips, which are regarded as the highest-grade collateral, instead of Treasuries saving them up to 40bp. The challenge in getting these types of accounts involved in the market is in delivering the Tips asset-swap package in a form that overcomes the system and accountancy issues.
Raj Shah, Royal Bank of Scotland: It depends on who is looking at the asset swap in terms of value. One of the newer participants this year has been some of the smaller regional banks. Their funding levels have improved dramatically from last year and now they can fund at Libor-negative levels. So, when they see 10-year Tips on asset swap that are paying Libor+50bp, it often provides a much better return than some of the assets that they held before. Also, Tips have the added benefit of being US government credit.
Other participants in the asset-swap market who see value in them are money market funds and repo desks. One of the ways you can determine the value of Tips on asset swap is to compare them with nominal bonds on asset swap – that’s the nominal bonds that trade against the Tips to form the breakeven yield spread.
Although we don’t have the same sort of spread of ASW spread levels that we did last year between the two, I think that in the sub-five-year sector we still see decent spreads. We know that repo desks are looking for spreads of 20–25bp – they are happy to lock that spread in and take the MtM risks between the Tips and the nominals.
We might face a few hurdles going forward, though – the main one being supply. Tips are probably going to grow to $125 billion next year and that could put significant pressure on the asset-swap levels. We’ve had a very strong rally this year, so there are some participants who look at cross-currency market trades and we are getting to levels where UK linkers are cheaper on an asset-swap basis compared to Tips, and I think you might see some portfolios unwinding Tips and moving into linkers on asset swaps.
Dariush Mirfendereski: One of the differences worth highlighting is that, pre-crisis, the buy-side for inflation-linked asset swaps was mostly dominated by hedge funds, whereas now real money is strongly involved, with a lot of buy-and-hold trades. This became true not just in the US market but also in the UK market where, pre-crisis, there were very few real-money asset-swap investors. When prices became extremely compelling post-crisis, it wasn’t simply a slightly positive carry trade or a small arbitrage; there was a massive arbitrage opportunity to get into the trade and that was why we saw this big price correction in 2009. Real money is here to stay. Nevertheless, it’s still a synthetic route of getting inflation-swap supply back into the market. Despite the asset-swap price correction, they’re still relatively cheap because there is demand for inflation swaps. Tips asset swaps will continue to trade cheap until we get natural supply of inflation swaps.
One other area worth pursuing is that there are a lot of buy-and-hold Treasury investors, the guys who have billions in their portfolios and they may not be too concerned about liquidity. If you can get those investors to instead buy Tips and put on an overlay swap to switch into fixed, they effectively construct a portfolio of Treasuries at a higher yield. They’d be holding the same issuer’s paper, but getting a pick-up over the nominal yield they were getting before. That is another way of getting investors involved to counter any moves that may sharply cheapen asset swaps as a result of market dislocations.
John Harrison: Looking at the difference in the asset-swap-spread structure in the US and the UK, you can see the effect that the pension fund buying of asset swaps has had in the UK and the potential for further upside in the US. The pension funds have the advantage of large balance sheets, long-term investment horizons and (because of their liability-driven investment (LDI) history) a capacity to transact inflation swaps. As the pension funds are driven by a Libor-linked target for asset returns and are looking to invest money for 30+ years, they are relatively indifferent to buying index-linked asset swaps compared to nominal swap spreads. This has resulted in the pick-up compared to nominal bond narrowing from five years out to 50 years compared to the US where it slopes up out to five years and then is largely flat.
Michael Anthony: This is obvious, but we’re entering a point where two-year yields are at 49bp and five-year yields are 1% and 1.25%. The additional 10–15bps that you earn from a Tips asset swap is going to draw a lot of investors. We’re potentially entering an environment whereby a new set of investors will come into the product because of what yields are in absolute terms.
Allan Levin: There is a view that increased issuance of Tips by the Treasury isn’t necessarily going to widen the Tips asset-swaps spreads. In fact, part of the logic of the US Treasury is that increased issuance in Tips – as long as it’s done in a regular and predictable way, which is the way they plan to do it – will actually improve liquidity in the asset class and make it more attractive as an asset class to a broad array of investors. There is a clear possibility that a reduction in the liquidity premium in Tips as a result may actually richen Tips asset swaps. So, in my mind, it may actually be an attractive entry point to invest in Tips asset swaps now, prior to the liquidity risk premium reducing.
Risk: What do the recent big trades between Fairfax and Pimco say about the buoyancy of US inflation options, and do you think this will encourage more participants to enter the market?
Carl Bonde, Citi: These trades recently made headlines after details about them were published in two articles in the financial press. After these trades became known to the broader financial community, we saw a drastic increase of interest and enquiries in inflation volatility products from various investors. This is both from accounts already active in the US inflation market and from accounts not previously active. So, yes, I think the publicity these two large sophisticated investors have had, with respect to inflation derivatives, will encourage more investors to participate in the US inflation options market. The increased interest of inflation options, floors in particular, is also a function of the current expensive levels of inflation volatility. Both year-over-year and zero-coupon floors trade at historically rich levels and, at these levels, investors are happy to take either side of these trades. Going forward, I think we will see increased liquidity across various products in the inflation volatility space as more and more investors get involved.
Risk: Do you have a view on where inflation volatility is and is that level justifiable?
Carl Bonde: Over the last six months there has been much talk about disinflation and deflation, and low-strike inflation floors have become quite expensive, both in terms of year-over-year and zero-coupon options. This is an effect of inflation expectations trending lower and volatility becoming richer. At the moment we have a skewed picture where low-strike volatility is expensive and high-strike volatility is cheap, reflecting the view that the market believes there is a higher probability of deflation than hyperinflation. This picture will most likely change as the Federal Reserve is expected to embark on another round of quantitative easing, there has even been talk about specific inflation targeting. Fears will probably shift away from a low-inflation scenario to a high-inflation scenario and the probability of higher inflation will increase and, in doing so, low-strike volatility will become cheaper and high-strike volatility will become richer. It’s difficult to say exactly by how much. Some say there might be too much inflation, it’s hard to say. Personally I don’t think so, as there are still problems like unemployment running at the highest rate in two decades, which has a negative effect on inflation. Overall, I believe that the probability of high inflation will increase and high-strike volatility should become richer and low-strike volatility cheaper in this case.
Alvaro Mucida: One of the reasons why high-strike caps are relatively cheap at the moment is because, in the first quarter of the year, there was a fair amount of structured note issuance with embedded caps, which brought some supply of caps onto the Street. The volume of these caps that went through the market isn’t large enough to provide supply for long. If investors started to come and lift these caps in size, the Street would be taken out of their legacy positions from these structured notes pretty quickly. This supply was mainly in the five- to seven-year sectors, which coincides with the cheapness in the caps. If investors take advantage of the current low breakeven levels and low implied volatility for these high-strike caps (at least compared to the floors) and start to buy them, the skew will definitely reprice very quickly.
We’ve talked a little about year-over-year options. In Europe, it’s not uncommon to find contracts indexed either to local CPI or European CPI with embedded floors. If we saw more of these contracts in the US – companies or investors who are receiving cash flows, through a lease or any type of future revenue stream with embedded inflation floors – they could monetise this by swapping the indexation out and providing supply of year-on-year volatility. It’s true that in the US there are very few of these contracts but, as long as investment bankers are aware that inflation volatility is rich, they could help their clients during the negotiation of contracts to try and insert these floors because they know that they would be able to monetise it and get some extra value. So there is an education process – we need to educate bankers and clients. If anyone in a position to negotiate a contract manages to insert inflation volatility there, there is definitely value to it. So I think that is one alternative path to generate some year-on-year inflation volatility supply.
Carl Bonde: Another way to get natural supply of inflation volatility is the development of inflation swaptions. An active market in inflation swaptions will enable dealers to issue callable notes to retail investors, which will provide much-needed supply of inflation volatility. At the moment, without an inflation swaptions market, callable notes on inflation have too much model risk in order to be competitive with callable notes in the nominal rates space.
Keith Price, BNP Paribas: The broader solution here is that we need to increase participation, not only in the derivatives space but in the options space. We’re going through a natural progression at the moment. The European market has always been very developed. We have participants who are natural payers linked to CPI, we have pension funds that are natural receivers, we have PFI projects, and so on. But, as this market becomes less opaque, partially due to people like D’Arcy who are now publishing volatility levels that we can give to our risk managers, and I’m assuming end-users can also give to their risk managers to develop their own volatility surfaces, this will encourage people to come into the market. We saw the financial press and the coverage of the big deflation insurance buyers in the market. You don’t know how many calls I got, asking: “Really? You can buy those things? What is that? What is a floor? You can protect against deflation in this manner?” Regardless of where you see valuations – we can argue about that all day, and maybe year-on-year is a bit rich. Personally, I think volatility is a bit rich compared to interest rate volatility, but you still have people in equity markets or some fast money accounts who like volatility, and they look at inflation volatility and they say, “you might think it’s expensive, we think it’s cheap”, and they’re going to buy it. But, as we get more exposure and more liquidity, it will attract end-users and then maybe we can come up with more ingenious ways to allay our year-on-year risk and we’ll be able to sell it on to somebody. We’re in the midst of that right now, and you see the growth in the inflation option market this year. You’ve clearly seen that it’s moving in that direction. I don’t think there’s anything that we as a group are going to be able to do intentionally to spur that more than we have, but hopefully we can keep on.
Risk: Whenever we talk about the US market, we tend to make comparisons to the UK market. What do you think are the biggest differences between the US and the European inflation markets? Are there any lessons that the US could learn from Europe?
Raj Shah: It has been mentioned a few times that one of the big differences is regulation. In Europe and in the UK, pension funds and insurance companies are required to hedge and manage their inflation exposures. There are no such requirements in the US now, although potentially there could be. That causes big differences in the way people behave. For example, the long end of the US inflation curve has very few natural buyers whereas, in the UK, there are many. We complain about our real yield levels right now looking expensive when 10-year Tips go to 65bp in real yield, but 40-year UK linkers are trading at 50bp. It shows there is very strong demand because of this regulation.
Another difference is the avenues of supply. In the US, you only have the US government supplying Tips and so you can only get zero-coupon supply through asset swaps. In Europe and the UK, you have private finance initiatives and utility companies that are happy to provide some sort of demand to the market. That is quite important because there are real-money accounts that like to diversify. They would maybe like to buy some corporate linkers or have another avenue of gaining inflation exposure, rather than just buying Tips or inflation swaps.
Another difference is the development of the two markets. The European inflation market in particular tends to be very efficient. It’s down to the number of people involved in that market compared with the US. Whereas a lot of the investors in the US tend to be buy and hold, in Europe you have more people who tend to be on the other side. It’s an important difference because we saw in the 2008 crisis that the European inflation market recovered a lot faster than the US market. Sometimes the inefficiency provides great opportunities for dealers and accounts to make a ton of money, but other times you’re stuck with risk that you don’t like. For the long-term health of the US inflation market, we need to move towards that level of development and efficiency.
Risk: Is that something that is improving?
Raj Shah: The market is developing. One thing that people think is going to improve liquidity is increased issuance. I don’t necessarily think that’s the case. The US market is already the biggest inflation-linked bond market. I don’t think increasing supply actually does translate into an increase in liquidity. An important development this year is the addition of a lot of new dealers because that means that, when you want to hedge, there are more chances of doing so. This is especially evident in the options market. It is improving, but there is some way to go before we’re at an efficient level.
John Harrison: One bit I’d add to that is on the very long end of the curve. The 30-year bond that has just started to be issued has proved quite difficult to trade so far this year as the main hedge against it has been the 2029 bond, which has made the spread volatile. If the Treasury sticks to the plan of increased issuance, we will end up with a group of 30-year bonds, which can trade against each other, hopefully reducing the volatility of the 20-year to 30-year spread. As for who would be a natural buyer of the long bond issuance, the obvious answer is pension funds. Pension funds have long-term inflation liabilities and the fact that they are not realised on balance sheet does not mean they should not be hedged.
Keith Price: A bigger hurdle with pension reform is the cultural issue. Our pension funds have liabilities, but Americans love equities – they have always loved equities. To persuade a pension fund to divert from that strategy is going to be very difficult without proper legislation. Even in the UK where it is less ‘equities-centric’, it took legislation to get people to employ their LDI strategies. But, here in the US, people are not going to want to match those liabilities, especially at the real rates that we’re achieving now – 0.6% at the 10-year or even further up the curve. Until that happens, I don’t see the overall development of the derivatives market taking off like it is in the UK or even in Europe. However, we are making substantial steps. We need more dealers. I’m always happy to hear of new dealers coming to the market, especially a dealer who wants to take risk because it makes it that much easier for me to lay my risk. Hopefully their client base is different from my client base. The more the Treasury does issue, the more liquidity we will have and the more developed the derivatives market will become.
Michael Anthony: We’re all sitting around this table debating ways to increase the number of people active in the inflation space, whether it be zero coupons, options or Tips. The US Treasury has a mechanism whereby they think that this increase in issuance is going to solve this problem and everyone’s going to get involved. But I think that the real question we have to ask is: is regulation the only reason the European and the UK markets work? Is there an actual need for investors to hedge inflation, or is inflation something that people are generally happy to just hold either because they think it’s mis-priced or they think it’s part of their natural life and they’re happy to keep whatever risk they have? To some capacity, we need to ask ourselves as a group of derivatives market makers: is regulation the ultimate endgame for the US derivatives market? Personally, I think the answer is most likely yes for a variety of reasons. I think, given the way the world has changed and the way that we are now in an extremely low-yield environment, it becomes much more relevant than it used to be, particularly for pension funds that may not be able to meet their obligations.
Risk: Does anyone have any thoughts on where US inflation might be headed and how that might affect the development of the market?
Nikolay Stoyanov: It is probably more of a bi-model distribution because inflation prints tend to be somewhat auto-correlated, so the trend tends to persist for some time. If I have to choose between the two, I think that inflation would go up.
Higher inflation tends to attract more people to the market. Alas, many people tend not to be concerned with inflation when the published CPI numbers are low, but become concerned when those numbers start to print high. Unfortunately, by that time the market-priced future inflation is already high, not quite the best time to hedge. One should try to hedge inflation when there is little concern about it because that’s when the hedge would be cheaper. It is somewhat ironic that, from a market-maker point of view, it feels that some hedging against deflation is a business hedge, as trading volumes tend to rise with higher inflation prints.
Risk: Does everyone agree that high inflation is favourable for the US inflation market?
Michael Anthony: It certainly makes things more attractive. You’ve got 5%, or what you think is a 5% return on inflation then you’ve absolutely got to get more people involved in the product but, as I mentioned before, people are happy to keep this risk oftentimes unless it becomes something that’s a valid return and a potential profit, it’s just not going to be interesting for many people.
Keith Price: It is an interesting phenomenon we saw in the second half of 2009, when we got stuck with the year-on-year prints that were much higher, the retail space just exploded. We saw $400 million/$500 million of new capital coming into new products, exchange-traded funds, Tips funds in particular. Where the unsophisticated investors thought they were protecting themselves, I don’t think they thought of it as much as a macro play as a reaction to financial media and a re-normalisation in Tips breakevens. But they saw the outperformance of Tips and inflation-related products to nominal products, we saw a huge influx into these products. These were real rate products and so, as we see a decline in expected inflation over the next couple of years, it would be more muted. We’ve seen real rates go straight down. So in actuality, the return in these products would have been much greater so far this year versus what it got in 2009.
Risk: Disregarding the actual level of inflation itself, how do we see the US inflation market progressing over the next few years in terms of liquidity, products and themes?
Keith Price: As inflation becomes increasingly prevalent in today’s financial lexicon for a myriad of reasons, including quantitative easing and deflationary scares, the future of the inflation derivatives market looks exceptionally bright and we stand to be one of the major beneficiaries. With major focus on inflationary and deflationary risks, we have already begun to see the natural progression and dynamic tranformation of our market through increased liquidity and innovative new approaches to inflation hedging and speculation. As evidenced by this forum, there is renewed interest in our product. Only two years ago I would be sitting here with three of my counterparts and not eight, and this speaks to the health and resurgence of our market. Increasing demand from clients is being met on several fronts and I see that trend continuing. Liquidity will continue to improve and pricing will continue to become more transparent. I believe trend growth in these products will far outpace growth in the majority of other interest rate derivatives markets and should be led by increasingly liquid inflation options activity. As our options market develops, possibly this will lead to a structured product market that may one day become tradeable over the counter. Overall, I am exceptionally optimistic about the future possibilities in my market.
Raj Shah: One thing that is possible is the development of Tips futures. The Chicago Board of Trade has looked at this in the past and they didn’t go forward with it because they didn’t think there was enough demand. But, in the scenario of significant, new demand for Tips, we could see development of Tips futures, which could give you a lot more liquidity. That would be good for the industry.
Allan Levin: One clear development that we are going to see is that there will be new ways in which to access the inflation market, whether it be through futures, inflation-focused funds or insurance products referencing CPI. Investors want convenient access and there will be efforts made to fulfil this need. In addition, there is going to be a trend towards more exotic products. Many of the lightly structured products that are currently available in the nominal market will gradually migrate to the inflation market.
Carl Bonde: I agree with that. Going forward, I think we will see a broader scope of inflation products being offered to clients and traded in the interdealer market. However, we are not there yet; at the moment we do not have some of the fundamental building blocks like inflation swaptions, for example, which is important in order to price more exotic derivatives such as callable contracts on inflation. Most dealers can probably price these types of trades but there is still too much model risk, which you will have to warehouse until this risk can be offloaded. As we get more players involved and liquidity improves, I think there will be a natural development of more exotic inflation structures. A key factor to getting this going is to educate accounts starting with standard options to more complicated structures and show customers the various opportunities there are in the US inflation market.
Inflation seems to be on everybody’s mind at the moment. Accounts are concerned about inflation being too high or too low. Liquidity in the interdealer market is at the highest levels ever, which means that we can provide our clients the very best possible service because we can offload some part of the risk. Also, most dealers have experienced increased interest from customers in the inflation market. Given all these facts, I am positive about the current state and future of the US inflation market.
Keith Price: I think that, in our space, we’re in a healthy, positive space. I think we’re growing, we have a robust market. Visibility has increased due to press coverage in the eyes of clients. Transparency has increased, which is always helpful. Among us, liquidity has increased. We’re at critical crossroads for the macroeconomic perspective. Will quantitative easing round two or round three work? I don’t think that increasing people’s inflation expectations will give them purchasing power, I think that will be more for the labour market. Going into a Japanese scenario will be very horrible for us as a whole, not just as inflation traders, but as a country. So I think it’s very critical but, either way, the focus is on inflation. At a recent conference recently, someone asked me if I believe in inflation or deflation. I said yes. As long as that scenario is true, it’s good for us. We’re a very innovative group and I think that, with professionals like ourselves, with our structures and with our clientele, we will always be trying to find a solution for a problem. As general liquidity increases in this market, we’d be able to come up with much nicer solutions for the end-user. I don’t see why any progress should be stopped there. Hopefully 2010 for us will be like 2004 was for the UK.
Raj Shah: One of things that we’d mentioned is the Federal Reserve considering another round of quantitative easing and the risk of high inflation associated with that. The way the Fed is thinking about quantitative easing is that they want to avert disinflation. That is what they are looking to make happen. Quantitative easing doesn’t directly affect inflation, but it can increase inflation expectations, which might give us more power bargaining wages and perhaps increase consumption. The fact is that consumers’ balance sheets are still very bad, so we’re probably going to have a period of low inflation rather than deflation or high inflation.
Alvaro Mucida: We’ve talked about swaptions and other, more complex, innovative products, but there is still quite a bit of divergence among the Street’s models for options. For things that have been around for a long time, like year-on-year inflation swaps and options and forward-starting swaps, there isn’t yet a real consensus about what model is best and how to calibrate it to calculate the convexity adjustments, for example. I think there is still some work to be done before we can actually move forward and start trading more complex products that depend on these more basic building blocks, but we are definitely moving in the right direction. I think we are experiencing a kind of virtuous cycle at the moment, with client interest generating press about the product, which in turn generates more client interest, which helps liquidity and spurs growth.
John Harrison: I’m optimistic about the US inflation market – with the increased issuance of Tips from the Treasury, the amount of coverage in the press and the amount trading in other currencies – I think there are clear upsides to the US inflation market over the next couple of years.
Michael Anthony: Just to look at the big picture again, there’s a perfect storm forming for this market to truly take off – the culmination of increased issuance from the government, massive support from the Treasury, potential reform in many capacities that will really allow the derivatives market to benefit significantly. The one thing that we all have to take away is managing the challenge to help the market understand that this is a real risk for them and it’s something they need to consider and be concerned about.
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