There continues to be uncertainty about the direction of US inflation, particularly given the latest attempts by the Federal Reserve to stimulate growth, known as Operation Twist. This uncertainty is encouraging a broader range of investors and hedgers to enter the US inflation derivatives market, according to senior inflation experts in a panel discussion sponsored by BGC Partners in New York recently
Bank of America Merrill Lynch Prabhat Arora, Vice-president, Inflation Trading
Barclays Capital Nikolay Stoyanov, Director, Inflation Derivatives Trading
BNP Paribas David Pereira, Vice-president, US Inflation Trading
Citi Andrew Henson, Inflation and Cash Tips Trader
Credit Suisse Robert Tzucker, Inflation Derivatives Trader and Director
Deutsche Bank Allan Levin, Head of Inflation Trading, North America
HSBC Evan Guppy, Director, Inflation Derivatives Trading
JP Morgan Alvaro Mucida, Executive Director, Head of US Inflation Derivatives
BGC Partners D’Arcy Miell, Global Head of Inflation Products
Risk: Let’s start with the question of how volumes in US inflation swaps have held up over the past year. What have volumes been like?
D’Arcy Miell, BGC Partners: Over this past year, we have seen considerable growth in the market – across swaps, asset swaps and options, with volumes up 70–75% compared to last year. The majority of that growth is in options, with an increase in the volume traded of around 200%. Elsewhere volumes are up around 50%.
Allan Levin, Deutsche Bank: The growth in volumes reflects an increase in the number of participants in the market. A good number of our trades have been with clients who had not traded inflation prior to 2011.
David Pereira, BNP Paribas: The growth in the derivatives market is also the resultant of the significant increase of activity we witnessed this past year in the cash market (Treasury Inflation-Protected Securities – Tips). A lot of players have been looking at and taking more interest in inflation and real rates in general, with the past 18 months’ volatility and the absolute level of real rates in particular. As a result, we got a natural increase in inflation derivatives, with more accounts managing the inflation risk embedded in their portfolios and taking advantage of some market distortions.
Evan Guppy, HSBC: What we have seen this year, probably across most markets, is that investors are trading more from the point of view of fear rather than greed. As a result, there are more people who are looking at inflation because of quantitative easing and high headline rates of inflation and thinking this is something they need to be concerned about.
Risk: To what extent is the market for US inflation contingent on the asset swap market? To what extent does that have an impact and what other sources are out there when you look at it compared with Europe?
Alvaro Mucida, JP Morgan: Asset swaps are still the major source of supply of inflation derivatives. One relatively new development in the market is that a broader base of clients is getting involved on the sell side, paying inflation. That includes real money, hedge funds and even insurance companies and pension funds, which historically had been exclusively receivers. The low real-yield environment also helps by bringing in people interested in paying real yields, which works effectively as supply of inflation derivatives. Then there are the traditional textbook sources of inflation derivatives such as infrastructure and utilities, but the Street hasn’t been very successful in sourcing from them so far. There are a number of initiatives that are trying to get more infrastructure projects going in the US, like the creation of an infrastructure development bank. That could be very positive for the future of inflation derivatives, but it is still further down the road.
Prabhat Arora, Bank of America Merrill Lynch: We have seen real-money players pay inflation, especially when forward inflation gets to certain levels that are perceived to be too high. That’s something new and it has also been a source of inflation supply for the Street in swap format.
Risk: Is anyone interested in inflation protection now? We’re still in quite a low inflation environment.
Evan Guppy: Headline consumer price index (CPI) is 3.9% in the US. That still tends to grab people’s attention. For overseas investors – the overseas central banks, European banks, UK- or Asian-based insurance companies or asset managers – one of the things they are concerned about when investing in US markets is the strength of the currency. One easy way to mitigate risks against currency depreciation is to buy inflation protection via the cash market, derivatives or options. In the past 18 months, we have seen people who hadn’t looked at inflation before suddenly have inflation on their radars.
Risk: Do you see a similar trend in client activity at Citi?
Andrew Henson, Citi: We’ve seen a few equity accounts come in. We hadn’t seen equity participants in the inflation options space before. A lot of them are hedging equity positions with long floors. That, along with positioning for protection, is something new to the market and is really making the inflation options space much more liquid. We no longer have everybody wanting to sell floors – we actually have buyers of floors on the other side. There is also that much more uncertainty in the eurozone. Given that risk, we’ve seen euro accounts doing cross-currency trades where they look at our inflation, realised inflation versus implied volatility, and it looks fairly cheap on inflation long-term implied volatility versus euro volatility.
Robert Tzucker, Credit Suisse: Even if you believe that inflation might be quite low for a little while, the range of possibilities and outcomes of inflation are quite wide. With central banks printing money to try to get out of their problems, there is tail risk to the upside. If we get into the Japan scenario, there is tail risk on the downside. There is a variety of views and that’s something that helps the inflation volatility market grow. At the same time, it helps inflation products because investors see inflation products as a bit like insurance.
Risk: Is there still some interest in deflation hedges?
Prabhat Arora: A number of equity hedge funds and portfolio managers have shown an interest in deflation protection this year. The bulk of their portfolio gets hurt significantly if there is a realised deflation scenario, so buying deflation floors is a good tail-risk protection strategy. Compared to some of the other options that are available for tail-risk protection, deflation floors are still relatively cheap because there is a decent supply of these through issuance of Tips and subsequent asset swapping of these Tips.
Risk: What do you think of the way liquidity has developed in the market over the past year? Are dealers able to get large transactions done?
Nikolay Stoyanov, Barclays Capital: It’s probably back to pre-crisis levels of 2006 and 2007. There are two ways we can judge that. One is by how much a large transaction will move the market, and it’s not that much. Two, you have broker quotes basically – quoted by us, essentially – that are within a couple of basis points that nobody is hitting or lifting, which means that everybody is fairly certain where actual levels are. There is also another aspect to this. During the crisis, the spread between Tips breakevens and inflation swaps widened dramatically. The primary reason was balance-sheet concerns. This has largely decreased as a concern. If we look at Tips on asset swaps versus their nominal counterparts, that spread is back to what it was at the pre-crisis level. There is still demand for asset swaps because people are still chasing yield, so that keeps the market well supplied with synthetic inflation payers. The new development is inflation options. The market was non-existent a few years back. Now, there is a fairly good agreement over option pricing. It is interesting because, in a less developed market, you would expect a large divergence in way-out-of-the-money strikes and, while they have the greatest divergence in terms of dealer pricing, there is still what I consider to be a relatively tight agreement.
D’Arcy Miell: The interbank market has become far more liquid over the last year. More market-makers are providing liquidity on a daily basis, and spreads are tighter. As Nikolay pointed out, we have markets quoted that are 1–2 basis points (bp) wide. They will be there all day long – they may move with the market but they are still there. People are becoming more confident about where things are, which I think is a good thing. The liquidity that was missing from the market on a day-to-day basis a couple of years ago is now here.
Evan Guppy: The interbank market is being a bit more sensible than it was in 2008. It is also down to the way in which the clients have been educated about how the market works. So I think there is a little more understanding that, if you want to do a big clip of Tips or a big clip of inflation swaps, the way you execute that isn’t the same as it would be if you executed Treasuries. Maybe in 2007 and 2008 investors would have thought: ‘well, I’ve got a big trade to do, I’ll do it exactly the same way I do Treasuries – I’ll ask five people for a price and deal with the best one’. While liquidity in inflation is a lot better than it was last year and the year before, it is still a different and smaller market. The experience that clients have had in the past few years has educated them that the way they need to execute is to be more sensible and considered – whether that is working with one or two big, trusted dealers when they’ve got a large trade to do and being more patient about doing large size.
Risk: One thing we alluded to about liquidity is the presence of real money and real players. Can you talk about how their presence is growing?
Prabhat Arora: Real money has been quite active this year and this is a very positive development. Real-money players typically tend have a longer-term investment view and also the capacity to hold risk longer, which has helped to make our market more stable and balanced. The inflation derivative market also tends to have dislocations or opportunities to earn significant returns from time to time. Real-money clients are well positioned to take advantage of these dislocations and add alpha to their portfolios, so it’s a win-win situation for both dealers and clients. We have seen real-money involvement in a variety of trades this year. Increasingly they are taking views via inflation swaps on different parts of the curve, long or short, instead of just doing it via Tips. Also, forward-starting swaps have been popular this year– for example 5-year/5-year or 10-year/10-year swaps – as these enable real-money accounts to express views on forward inflation easily. Another trade that has been popular is buying or selling CPI swaps versus Tips breakevens. Real-money accounts are also taking views on inflation volatility via at-the-money, year-on-year options. So it has been pretty broad-based involvement from real money.
David Pereira: The spectrum of players on the inflation derivatives market has been growing, with real-money players taking advantage of opportunities in the derivatives inflation market, both on asset swaps as zero-coupon swaps and on options. The arrival of these accounts in the inflation market is a strong signal that liquidity is there for sizeable transactions and will now also attract more players such as proprietary desks and hedge funds, as potential central banks. We have recently received such requests.
Allan Levin: There are some fairly large real-money accounts that have historically focused more on Tips. These accounts have broadened their mandates to allow trading in inflation derivatives as well. Accordingly, they are now trading inflation derivatives as fluidly as they traded Tips. Trading volumes have also improved due to product development, for example, new mutual funds that explicitly include in their mandates the ability to trade inflation swaps. Not only are established real-money accounts trading more actively in inflation derivatives, but also newer players have entered the market with the intention of actively trading inflation derivatives as part of their mandate.
Furthermore, there have been two clear themes that have encouraged derivatives trading. First, overlay usage – many asset managers invest in corporate bonds or other assets in order to earn the corresponding risk premiums from these asset classes. By overlaying inflation derivatives, they are able to continue to earn credit spreads or other sources of alpha while obtaining inflation protection as well. The second theme is with respect to forward trading. At the beginning of the year, volatile movements in gasoline and oil had a significant impact on spot-starting inflation swap prices. It was recognised that forward trading was an effective way to trade the inflation markets without having to be concerned about short-term movements in commodities or even seasonality. So it freed participants to focus on long-term inflation prospects without worrying about short-term dislocations – which made many participants much more comfortable in trading inflation derivatives.
Risk: You mentioned volatility in oil. A big theme in the market this year seemed to be uncertainty. How has that affected the inflation market?
Robert Tzucker: Uncertainty is great for a lot of markets but it’s only good in as much as people are still willing to trade during that uncertainty. In inflation, people were trying to find protection. The more uncertainty there is, the more they desire protection, the more business we do, the more liquidity we have. There are a lot of people looking at the energy markets who like to trade it versus inflation products. They look at oil futures versus the front end of the inflation market, or options on energy and options on inflation, and compare the two markets. If the larger spot volatility is driven by something like that, it will bring people to look at the relative value between markets.
Alvaro Mucida: I agree that uncertainty about the real economy, employment and inflation itself is positive for the market. The type of uncertainty that maybe is not so positive is when the market is particularly concerned about potentially disruptive events, which discourage people from trading, as Bob pointed out. So, earlier in the year, we had the debt-ceiling debate in the US and now we are experiencing the European crisis; these types of situations inevitably bring back some memories from 2008 and can reduce liquidity. Still, even under these circumstances, volumes have held relatively well this year, which demonstrates that this market is maturing.
Risk: What do you think of the current level of US inflation swaps and asset swaps?
Prabhat Arora: It comes down to one’s view on the US economy and the situation in Europe, but there are some compelling trades out there. The front part of the swap curve is relatively cheap, and you need to have a pretty pessimistic view of Europe and commodity prices for the levels to be justified. As soon as we have some kind of resolution of these issues, we should see a snap-back higher in the front part of the curve. Asset swaps are also cheap, especially in the long end. We’ve already seen that correct in the past week. But, even at these levels, longer-dated asset swaps still make sense for buy-and-hold-type accounts.
Andrew Henson: There is still room to go on the longer-dated asset swaps as a Libor pick-up, purely based on the fact that we are in such a low-yield environment and we’re seeing real-money accounts selling straddles in the nominal space just to pick up another 5bp or 10bp. That spread between 30-year Tips on asset swaps versus 30-year nominal asset swaps will continue to tighten as we see more yield enhancement trades.
Evan Guppy: One of the things we’ve seen recently is interest from UK pension schemes, which over the past three or four years have been quite active in the long end of the UK asset swaps market. They have started to look at Tips and say, well, these headline levels relative to nominals and relative to where the UK asset swaps are trading are actually quite cheap. So we see more and more people getting involved in the US market and, increasingly, it seems to be these guys in the UK looking for value outside of their own market and looking for Tips on asset swaps as a way of picking up extra yield.
Nikolay Stoyanov: There have also been opportunities over the past couple of weeks for people who are willing to hold their positions a little longer. These arise due to the third round of quantitative easing. The Treasury programme will also involve the buying and selling of Tips, which would obviously affect the bonds. But that operation, in reality, has little to do with inflation expectations. So, once the Treasury announced it would be selling short-end Tips, those Tips cheapened significantly on asset swaps. Some of that cheapening has since reversed, but I still think there is room to richen the levels of these relatively short-term maturities asset swaps.
Risk: Do you have any thoughts on the impact of quantitative easing and the Fed’s intervention in the market?
Alvaro Mucida: Nikolay already pointed out that the Fed selling the front-end Tips cheapened them a lot, although this has already reversed quite a bit. Operation Twist and the previous rounds of quantative easing also created interesting opportunities in the long end of the market, particularly around the Fed operation dates and we’ve seen more participants playing in the long end of the curve. Obviously, the market tends to price things as information becomes available and it doesn’t wait until the Fed acts. I personally think that Operation Twist is priced in for the most part. I also think that the additional liquidity that the Fed operations have created enticed more participants to take views on the curve of both inflation swaps and Tips real yields and the market as a whole benefited in that respect.
Robert Tzucker: Operation Twist is not in itself inflationary. Printing money in itself is not inflationary. You have to have a fiscal response as well. What you get is a situation where premiums are higher for being long inflation because, if you push this money cranking from the three-year sector out to the 30-year sector, it gives the government 27 more years to take that money and hand it out and spend it through some programme. Anything they can do to get that money out into circulation could be inflationary but, by itself, I don’t think the money printing does it. However, I do think it should heighten people’s awareness and increase risk premiums and therefore increase uncertainty and probably tail hedging strategies.
Alvaro Mucida: The other consequence of the second round of quantitative easing was inflating asset prices in general, including commodities and stocks, which of course indirectly had an effect on our market as well.
Prabhat Arora: It will be very interesting to see how the market handles the first couple of sales in the front part of the curve, i.e. sales of $1 billion to $1.5 billion of front-end Tips. In a normal market, at current levels, it wouldn’t be a problem as, duration-wise, it’s not a huge size. But, if we continue to get negative headlines from Europe, it could be tricky for the market to take down the supply, especially because people still have the memory of late 2008, when front-end Tips performed really poorly. Macro factors would be important to see how this twist pans out.
Robert Tzucker: For a lot of real-money participants, the short-end Tips have to be very cheap for them to want to get involved because it takes a lot of them to move the needle on their returns and, therefore, it becomes pretty balance-sheet intensive. That’s one of the reasons that, if we get this news out of Europe, it can snowball. You could see these things depressed below fair value for quite some time and quite a bit below fair value before we see buyers come in.
David Pereira: The Fed operation, particularly on the long end of the curve, has already been priced, and the impact on the breakeven curve has been to flatten it even more than the nominal market, given the size of the Tips market in comparison. The impact on the derivatives curve has been similar, opening up opportunities with low inflation forward swaps for long-term-view investors and opportunistic players.
Allan Levin: There has been mention of a fear of a 2008-type dislocation in front-end Tips and Tips in general. This type of crisis is less likely now than it was then for two reasons. First, now that we know that this scenario can happen, many of us have taken measures to protect against it. Accordingly, dealers’ and other participants’ books are much cleaner. Second, there are many more value-oriented accounts that are waiting for opportunities to arise in the inflation markets. Should prices drop too low, many of these players will pounce on the opportunities; whereas, a few years ago, they realised that the opportunities were there but were not yet set up to take advantage of them.
Risk: One of the phrases being used a lot is “risk-on/risk-off trades”. To what extent is that idea relevant in US inflation, and what impact does that have in the market?
Andrew Henson: It relates to the earlier question of uncertainty and, whenever I hear risk-on/risk-off, I always think bid/offer. The risk-on/risk-off trade is a little bit better for the dealer community in the derivatives space, aside from the fact that it does increase the illiquidity premium that the clients face. But, from a dealer community, I think it increases two-way flow because you have more uncertainty in the inflation path for the next couple of years. So really, we’ve seen more risk-on/risk-off type trades in the form of buying high-strike caps and low-strike floors. So we’ve definitely seen the risk-on/risk-off trade from our client base, purely because it is cheap. There is a high correlation right now and high betas being exhibited in the Tips market and, I think if you are going to take a view on the inflationary path, you probably should be hedging a tail-risk event caused by a risk-on/risk-off trade at the moment. We’ve seen a kind of a shift in overall investment strategy to hedging against a risk-on/risk-off type trade.
Risk: And participants have been involved in that?
Andrew Henson: It has been a very different client base over the past few months. We’ve seen equity hedge funds coming in and buying low-strike floors on the -2%, -3%, even -1%. We’ve seen accounts hedging doing covered-call positioning – so, buying 30-year breakevens or 30-year swaps and selling a high-strike cap to fund the downside. I think, when you start to get more and more risk-on/risk-off reversals, you see more hedging strategies. We’ve also seen more accounts coming in as we start to see the risk-on/risk-off trade normalise and a risk-on rally. We’ve seen more accounts coming in to look at 2012 asset swaps as a normalisation trade. We think that is fairly cheap.
Risk: One of the big stories last year was the high-profile inflation options trade. Do you see that interest in inflation options sustained?
Allan Levin: For sure. At the start of the discussion, it was mentioned that volumes are up 200% in the interbank market. We see the same in terms of client volumes. Perhaps the high-profile trades gave comfort to other investors to get involved. There is much stronger interest across all options – both caps and floors, different strikes, different maturities, from both fast money and real money. In every way, the market seems to be growing very rapidly. Some aspects have evolved; many of the trades last year were directional – either someone just buying or just selling an option and taking a view on the direction of inflation or volatility. We now see many more relative value trades; so clients taking a view on one strike versus a different strike and buying a cap spread or a put spread. Or taking a view that certain maturity options are expensive relative to other maturity options, so we’ll see participants sell long-dated options and buy short-dated options, or vice versa. Liquidity across the whole volatility surface has improved and more sophisticated strategies are being employed.
D’Arcy Miell: We continue to invest in the technology for Indicative option pricing as we see the growth potential of the market. We believe having a more accurate pricing system for indicative purposes will help us broker more effectively – that said, we are helped very much by the liquidity being provided by market-makers on a daily basis.
Andrew Henson: On Allan’s point about relative value in the options market, as we get a firmer volatility surface on the wings, we see more relative-value options accounts comparing implied volatilities across different products and taking relative-value positioning on that basis alone, instead of just purely directional options trades or hedging strategies. Accounts are coming in and selling 0% floors with purely a view that the probability on -1, -2 versus nominal or euro skew is too high, which is a newer strategy in the inflation volatility market. I believe there is much activity at the wings. That is the natural business and it is like insurance. There is really no need to buy at-the-money options.
Prabhat Arora: There are some very interesting opportunities in the options market. Zero-coupon floors offer a way to hedge against a tail deflation scenario. These floors have richened up in premium over the last two to three months but, even at current levels, especially longer-dated zero-coupon floors offer good value. As far as year-on-year options go, negative strike floors are very expensive on a normal volatility basis and, for accounts that have a view that inflation is going to be high, it makes sense to sell these floors either outright or against buying some protection in the form of nominal volatility. Another trade that still makes sense is selling year-on-year floors to buy year-on-year caps. There is supply of year-on-year caps through structured note issuance, so they trade a bit cheaper than the floors, and clients can get into trades with pretty good optics and risk profile that are essentially costless. We’ve also seen some view-taking on at-the-money straddles in inflation, which is something new in the market.
Risk: Before the crisis, we saw some volatility arbitrage hedge funds in the market. Has there been a shift in terms of the type of people involved in inflation options?
Prabhat Arora: Equity portfolio managers and hedge funds have been involved this year. Other real-money accounts, after looking at the Pimco trade from last year, have also shown interest in monetising some of the Tips floors they own. It is a tough environment for pension funds and real-money managers because of low yields and the inflation options market is an opportunity to earn extra returns, as there are still some glaring dislocations in these compared to other asset classes.
Risk: Have we seen any other developments on the more exotic side?
Allan Levin: There has been stronger issuance of inflation-linked notes, this year – approaching $1 billion in the US, especially from dealers that have a higher cost of internal funding. Most issuance has been fairly lightly structured, with the occasional more exotic offering.
Nikolay Stoyanov: Inflation-linked note issuance saw its boom in 2004 and 2005, and then it died out and, throughout the crisis, was virtually non-existent. It is good to see that there is now some resurgence in it. One billion dollars is still a far cry from what it used to be, but hopefully this is a start. This is basically where the global demand for the low-strike floors and the supply of the high-strike caps shows up. Right now, in order to provide a better pick-up for investors, these inflation-linked notes are typically associated with caps, so the CPI plus a spread coupon will be capped. These sorts of out-of-the-money caps give a good pick-up for the investor who thinks inflation may go up, but not quite so much. I’m probably a little more pessimistic on the development of exotics, purely because, prior to the crisis, there were various esoteric products that relied on inter-asset correlations, and they were priced with what turned out to be much too small margins of tolerance. The crisis essentially introduced a very different behaviour to all those correlations relative to any past calibrations or any past behaviour. So I think, to that extent, right now in more exotic pricing products you will have higher margins embedded that will be required from the trading desks themselves because they know what can happen now, and also by risk management at the banks. There is much tighter control on what type of products you’ll be able to come up with. So these higher margins, which in this case would rightfully be embedded, are probably going to be a little bit of a hiccup in the development of that market.
Risk: Let’s turn to that issue of the banking sector. There is a lot of new regulation coming in, in particular Basel III will bring with it enhanced bank capital requirements. How will this affect the inflation derivatives space?
Robert Tzucker: This is an extremely important issue. Credit Suisse is adopting this on January 1, 2012, so we are already dealing with these capital requirement issues. What this regulation does is it makes every swap you have count as a risk-weighted asset, and you’ve got to hold capital against it, so it is not so much a balance-sheet issue, but it turns your swaps into something that you have to be very careful of in terms of how much you have on. In effect, what it does is reduce the bank’s leverage and makes it much more difficult to be profitable. So you need to find a way to reduce the risk-weighted asset weighting of some of the longer-dated inflation. But this is not just an inflation problem, it is also a nominal swap problem. Reducing the impact that some of these trades have is going to be a challenge. It is likely to have to make people charge more money for longer-dated asset swaps and zero-coupon swaps – things that last a long time that are going to be with you. This legislation is meant to reduce counterparty risk, and so holding this capital against these trades is a way to minimise the impact in case we did have some sort of 2008 crisis and you have banks and customers disappearing. It is going to be a massive challenge. There are already things being done like mutual termination clauses, between banks at least, on long-dated inflation trades. However, that is not always done with customers, and also it is not clear whether the regulators are going to count that. If you have a 30-year swap with a mutual termination clause after five years, are they going to count that as a five year? It is not clear a mutual termination clause is going to clear that regulation hurdle. It may be necessary to come up with other creative ways to reduce the impact on the risk-weighted asset measure.
Evan Guppy: As an inflation swap market participant, the thing I am most worried about in terms of its impact on the development of the market is how it affects bringing new people into the market, particularly infrastructure companies and utility companies, where they feel like they should be a seller of inflation through swaps but are not in a position to do collateralised trades. The biggest impact from Basel III is trades where we don’t have a collateral agreement in place with a counterparty – it becomes pretty much penal to do trades with those types of counterparty in the inflation space. In so far as we want to have a market where there is genuine two-way interest involved, I think Basel III in its current form – and how the market is currently – might well scupper any hope of getting more natural supply coming into the market. Regulation isn’t entirely a brake on growth in the inflation market though, as the move towards exchange-traded derivatives and centralised clearing is, to some extent, good for investors, in so far as one of the things that would have scared people about 2008 was that they could have had a liability hedging strategy in place with Lehman Brothers and all of a sudden this whole hedging strategy has disappeared. You might think I’ve got 30-year liabilities and I’ve done a 30-year swap hedge but, all of a sudden, they are in a scenario where they need to go out and do those swaps again. Taking away that concern about counterparty exposure should be a good thing. It will cost investors and it will cost banks in terms of higher levels of initial margin and higher levels of collateral posting, but they are paying for something that they value.
Risk: Do you worry about real-money clients perhaps being put off by the possibility of having to post margin when centrally clearing through exposures?
David Pereira: This is a generic problem for all derivatives, and not specific to inflation derivatives, except one could argue that cash flow profiles on inflation derivatives (in particular long-dated zero-coupon swaps) could lead to large margin calls over the life of a trade. With the cost of cash and collateral being a real concern for all, such a constraint could definitely be a barrier, if not a deal breaker, for some operations. It is definitely a concern for the market-making side of the activity. On the other side, clearing inflation derivatives would minimise the systemic risk that any counterparty default could raise, and would also have the advantage for new players, currently limited by their mandate/regulations/credit risk to come into the inflation derivatives market.
As mentioned by Evan, in comparison to European and UK inflation markets, the US inflation market is still lacking the major and natural players that infrastructure and utilities companies represent, and new regulations would definitely trigger their arrival.
Risk: How will the US inflation market develop over the next year and will we see any further development?
Nikolay Stoyanov: I don’t think it will change that much. In the participant base, there will be an increase in the number, the liquidity is probably going to remain pretty good. What I would like to see – but I have little hope of this happening – is trading in sub-components of the CPI inflation. Right now, we only have headline inflation, and the reason we always stick with this is because the underlying Tips issuance, which in large part provides our hedges one way or another, only refers to headline inflation. But, over the years, we have occasionally been asked about core inflation alone, medical care inflation or education inflation, and those are trades that, currently, one would not even begin to price properly, let alone hedge. So, if we see something along those lines, then the inflation derivatives market is going to have a sure edge over the Tips market.
Another aspect of the inflation derivatives market that I believe is going to develop more is the options. Inflation options are what the derivatives market can offer that the cash market cannot. On the vanilla products, if you want to buy protection against inflation, there is always the trade-off of whether to use the breakevens or the swap. Tips are more liquid instruments, so they are often preferred if you have the balance sheet. But, for options, there is no equivalent barring the zero-deflation floor embedded in the Tips. So that segment of the market, I believe, is going to perform better on a relative basis.
David Pereira: I remain bullish for the prospects of the US inflation derivatives market. We are in a recovery phase and there is still growth until we reach past levels of volumes traded. Also, an increasing number of players are looking at inflation and real risks embedded in their books, on top of their interest rate risk, and, given that products and competitive pricing are available to answer these hedge requirements, it will naturally further increase volumes on the derivative space.
Before going into more exotic options, there is still a lot of growth in the vanilla options market, in particular with floors embedded in Tips. More and more, they will be extracted and traded separately as investors try to monetise them. There have been also lots of requests over the past year about Tips options, with investors holding large Tips portfolios sold such options to enhance their return. Note that we remain in a very low-yield environment (both real and nominal curves coupled with relatively high volatility), so such an environment would also be favourable to the inflation derivatives market in general.
D’Arcy Miell: There is going to be continued growth in the options space. I’ve had enquiries from some European banks that are on the verge of entering the US inflation space. I think they may be slightly put off by what is happening in Europe at the moment but, hopefully, when that uncertainty is removed, we’ll see those participants entering the market. There are about three or four banks that are at that juncture. So I do see the possibility for growth in the number of bank participants in the broker market, it bodes very well for the future. The options business has seen spectacular growth this year, and I think there is more to come.
Robert Tzucker: Tips options are definitely something that are being looked at by a lot more people now. In the investment world there are very few leaders and there are a lot of followers. Some of the leaders have started to get involved in this market, particularly the real money. Once these guys come in, it is not that long before we start getting more and more of the followers joining the market. That’s where our growth lies.
Andrew Henson: I am fairly bullish on Tips on asset swaps, and that will be the overall theme for 2012, primarily based on the increased issuance from the Fed. If you just look at year-over-year supply, it is increasing at a fairly healthy rate, which should help to increase interest in Tips on asset swaps, and possibly bring down the spread between nominals, just based on pure supply dynamics. One thing we haven’t talked about is possible inflation targeting for 2012. We are definitely noticing increased language over inflation bounding or staunch language on the parameters of what they see as a healthy inflation rate. It will be interesting to see how the inflation volatility market reacts if that comes to fruition.
Allan Levin: There are a number of key themes. First, I think more and more US clients will enter the market. A larger and more liquid market combined with an uncertain macro-economic environment and ongoing market dislocations is making the inflation market that much harder to ignore. Second, the world is continuing to be much more globally integrated, and I expect an increasing number of international players to enter the US inflation market to both diversify and take advantage of relative value compared to their own markets. Third, we are going to see an increasing level of sophistication. Now that we have a deep vanilla market, participants will become much more comfortable trading more complex relative-value strategies as well as inflation options, and the growth and liquidity in the inflation options market itself has made possible the creation of more exotic offerings, so I expect to see an increasing amount of innovation in the market.
Evan Guppy: I’m fairly bullish. I think more participants will continue to get involved, but that is kind of contingent on inflation remaining a key story. If we move into a Japan-style liquidity trap, where we are in a constant deflationary world, then inflation products aren’t going to be all that interesting. So, as long as we have that uncertainty about the macro-economic environment, where people are scared about the possibility of deflation and other people are scared about the possibility of high inflation, we are going to continue to see high growth.
Alvaro Mucida: I agree with everyone’s optimism about the prospects for the market next year. I think the growth in inflation options that we have experienced in the past couple of years is very interesting in that it happened without much natural supply or demand for certain types of options. So, even though there aren’t many people who are structurally short or long -2% or -3% floors or very high-strike caps, we still have had enough depth in the market for clients to get involved, taking views and providing liquidity. The fact that we have got to this level is very encouraging for the future and I hope we’ll be able to expand our product offering soon. For example, inflation swaptions would be a very exciting development that could happen in the near future. So far in our discussion we’ve been talking about caps and floors, but an inflation swaption would be a different animal that could take us to the next level and it could provide new opportunities for hedgers and speculators alike.
Prabhat Arora: One thing for certain is that 2012 will again be a pretty volatile year. There are elections coming up in the US, and Europe continues to have a lot of risks, so there is every reason to expect that we will have a lot of uncertainty about macro-economic data and policy direction. Due to this, we will continue to have clients with very divergent views on inflation going forward, and that bodes well for the inflation options market. There are other challenges coming down the road as well, like increased regulation, which hopefully also present some opportunities for dealers and clients.
BGC wishes to thank all participants for their valuable contributions to this forum and we invite any feedback and anyone interested to discuss these issues now and in the future.
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