US inflation markets have been through some major events in 2012, including the launch of open-ended quantitative easing and knock-on effects from the forced unwind of Greek asset swaps. Against a backdrop of continued economic uncertainty, a raft of new rules are set to come into effect in 2013. Sponsored by BGC Partners and convened by Risk, leading inflation experts discuss how the inflation market has reacted – and what the future holds
Bank of America Merrill Lynch, David Mehl, Head of US Inflation Derivatives Trading
Barclays, Nikolay Stoyanov, Director, Inflation Derivatives Trading
BGC Partners, D’Arcy Miell, Global Head of Inflation Products
BNP Paribas, Abhishek Nadamani, Vice President, USD inflation Trading
Citi, Carl Bonde, Inflation Trader
Credit Suisse, Robert Tzucker, Director, US Inflation Trading
Deutsche Bank, Karim Bendouma, Vice-President, Inflation Trader
JP Morgan, Alvaro Mucida, Executive Director, Head of US Inflation Trading
Royal Bank of Scotland, Mark Greenwood, Head of Inflation Options & Exotics
Risk: How has the US inflation market developed this year?
Robert Tzucker, Credit Suisse: The biggest thing has been the development of the customer base. We’ve seen a lot of domestic real-money accounts getting involved in this market and being able to trade on a tactical basis. This is a big turning point as it is becoming more mainstream – we even had some central banks looking at trading inflation swaps.
It is also the geography. We have South America, we have North America, we have always had Europe, and Asia is starting to look at inflation swaps in the US. The reason for this is the unusual opportunities in this market. If you look at our market, unlike the rate market, we have no zero bound. So it is interesting from a trading standpoint to be able to make tactical bets. Inflation can be positive or negative and real rates can be positive or negative in quite a large way, as we’ve seen.
Risk: There have been a lot of unusual market moves that have created trading opportunities. What have been the big events?
Carl Bonde, Citi: There were many events affecting the markets in 2012. One of the main events has been the situation in Europe. In 2011, Greece was in the spotlight and, in 2012, focus moved to Spain and Italy, on their debt levels and at what sort of rates they can fund themselves.
The US Federal Reserve policy has been very important, too. The Fed has made a couple of important changes. For example, it decided to extend Operation Twist and, in December 2011, the Fed changed its communication strategy to include the members’ view and expectation about employment, inflation and growth, as well as the expected future path of the federal funds rate. The Fed has also specified some sort of inflation target – it’s fairly vague to me, but nevertheless more specific than before.
Open-ended quantitative easing (QE) is the latest Fed move, which is particularly important to the inflation market. It is highly anticipated that, when Operation Twist ends, the Fed will continue to buy Treasuries.
On the political front, we had the US presidential election in November, which the market followed closely. Now we have the fiscal cliff looming and there is a lot of uncertainty about the outcome. Lastly, there are several important regulatory changes coming into play in 2013, like Basel III and Dodd-Frank. It is not clear exactly what the effects will be, only that there will be a profound effect on the market and how we conduct our business.
Abhishek Nadamani, BNP Paribas: The biggest event this year has been the change in Fed policy in September. Opening the door to asset purchases is a new and profound step, especially given the levels of breakevens going into the announcement. In past Fed actions, breakevens were much lower and, to us, this indicated the change in the Fed’s message regarding what it views as acceptable levels of medium-term inflation. Even though the market has given back some of its gains since, we see this as just temporary turbulence, and inflation expectations are going to continue to build as the market begins to realise what this really means.
Aside from the Fed’s actions, the Treasury inflation-protected securities (Tips) market was full of surprises. The inversion of the 10s/30s breakeven curve was one of the highlights for me. Part of this can be attributed to balance-sheet issues in September, but there is growing belief that the US could be the new Japan and the 30-year breakeven inversion is one of the latest market moves to lend potential support to that view.
The ease with which dealers took down the increasing auction sizes was yet another surprise. In 2012, the Treasury issued $150 billion and the Street has done a phenomenal job of taking this auction size increase in its stride. Finally, there has been increasing customer activity. We have seen many non-traditional accounts come to play in this market and this bodes well for the future of inflation markets in the US.
Nikolay Stoyanov, Barclays: The inflation asset class has continued to see increased participation both from the existing customer base as well as new clients entering the asset class. Furthermore, the relative fraction of real-money accounts trading the product has also increased. By and large, curve dislocations in both the cash and swaps markets were more attenuated in 2012. The continued richening of Tips asset swaps provides another clue. It results from both the greater demand for the cash securities and the demand for Tips on asset swaps directly in search of the extra yield they offer. The latter has been particularly helped by the Fed purchase operations and the crisis in Europe, which drove the yields of higher credit government securities very low.
Risk: How has all of this affected volumes?
D’Arcy Miell, BGC Partners: Volumes are up approximately 10% if you look across the board to include zero-coupon swaps, asset swaps and options – from 74 yards in 2011, to a projected 81.5 yards in 2012.
It is interesting to note that, although there have been some concerns about asset swaps being traded interbank, asset-swap volumes are actually up quite significantly on the year. I would attribute that to a lot of the trades being done in the short end of the curve, where there are fewer concerns.
The market has found a new source of liquidity this year with the re-emergence of basis trading – it has been around for a long time but never really took off until recently. A lot of basis trades are going through – mainly in five and ten year – so swap versus breakeven. Traders are using the basis as a way to get the liquidity they may not otherwise find.
Option market volumes are down slightly from 2011, although this is a marginal decrease. We had a quiet period in the first quarter of the year, however, from that point forward, the market has gotten steadily more active. With liquidity continuing to be provided by traders, I am confident that we will see significant growth in 2013.
Karim Bendouma, Deutsche Bank: We have been up in volumes in every inflation product – options, consumer price index (CPI) swaps, Tips asset swaps and Tips. We have seen more customers, whether it is purely for inflation, for real yields or for volatility. The inflation market still presents tremendous opportunities that have disappeared in other fixed-income areas – implied inflation volatility is still much higher than realised volatility, Tips asset swaps are still 20–30 basis points too cheap, etc. – and this is attracting a lot of interest from investors who never traded inflation. Also, as there is more liquidity, the bid-offer tightened significantly and investors feel more comfortable trading our products. The long end in Tips asset swaps is not very liquid at this time in the interdealer market because of credit support annex (CSA) issues, so this is something we need to sort out. But we had strong volumes there as well with our clients, notably early in the year when cross-currency swaps widened and international investors were looking to buy assets in the US.
Risk: There was some speculation about open-ended QE in advance of the Fed’s decision, so it didn’t come as a total surprise – but it obviously has big implications for inflation. How has the market responded?
Alvaro Mucida, JP Morgan: Open-ended QE was a huge event for the inflation market. The first reaction was for inflation expectations to jump massively but, since then, they have given back most of those gains. Even though forward inflation expectations jumped to the higher end of recent ranges, they never really got high enough to suggest that the Fed’s credibility was in check. I think what the price action told us was that the market still thinks there is not going to be inflation in the very short term, as the Fed, through monetary policy alone, just doesn’t have the ability to create inflation, and it is unclear how the economic recovery is going to play out and monetary policy is not enough to create inflation by itself. In early November, the Fed subtly hinted that it may be desirable for inflation to run for some time above the informal target, and still, over the past week or two, breakevens have fallen below where they were immediately before the QE announcement. A few factors contributed to that reversal, such as the plummeting energy prices and concerns about the fiscal cliff following Obama’s re-election. That created good trading opportunities because different investors have fundamentally different views on what that means for inflation.
Risk: How is the market positioning itself for the various tail events such as high inflation or deflation?
Karim Bendouma: We have definitely seen increased demand for tail-risk hedges – in zero-coupon floors especially, five years and ten years at a 0% strike or -1%. We can handle this fairly easily, we can replicate those options with asset swaps – they are the options that are embedded in Tips.
What has been more challenging has been on the higher side – tail-risk hedges for high inflation, so zero-coupon caps, and only a few in year-on-year caps via structured notes, so we either have to delta hedge them or take a position on the skew. The skew hasn’t moved dramatically for those maturities, so those trades haven’t translated into big moves in the market yet, but it could change. Early in the year, zero-coupon caps on euro inflation richened significantly due to large buying and the absence of selling, so it is possible we will see a similar move in the US sooner or later.
We have seen increased interest to be hedged against those tail-risk events but, because of the elevated price of the skew and implied volatility In the US, we have also seen good interest to sell those risk events, whether as an outright position or via covered calls or covered floors. So you buy Tips breakevens or an inflation swap, and you can sell a cap to get some extra carry. Or, if you are bearish, you could sell inflation swaps or Tips breakevens, and sell an inflation floor at the same time to get some extra carry as well. We have seen a fairly well-balanced interest in trading tail risk events, although the selling has been slightly more important, which can be noticed by the implied volatility cheapening slowly
Nikolay Stoyanov: I am not sure that, at this point, the market is worried about tail inflationary or deflationary risk. The implied volatility of the out-of- the-money deflation floors – for example, the frequently traded 0% zero-coupon floors – has fallen significantly, and more than the overall drop in implied volatility. Because the US inflation volatility market is relatively small, I’d like to look at the cash market. Investors implicitly put a price on their deflation worries, in part by the relative pricing on the curve of the most recent Tips issues as they have the most valuable floor. The comparison is easiest in the five-year sector, where the most recent issue is the five-year April 17 Tip, while its neighbours – January 17 and July 17 Tips – are old ten-year issues with deflation floors that have trivial values at this point. The implied volatility of that floor is quite low relative to the past couple of years.
To estimate how the market prices the risk of runaway inflation, we can look at some measure of inflation risk premium. A typical choice is to compare the five-year five-year inflation forward versus ten-year ten-year or ten-year 20-year. After adjusting for the choice of bonds, deflation floor and seasonality, the difference between the forwards is quite low and, if anything, was negative for a period of time this year.
The significant Fed purchases of the long-end nominal bonds contribute to the above, but I still don’t see a significant risk of runaway inflation being priced yet. Admittedly, if we compare one-year one-year forward versus five-year five-year forward inflation, the curve is quite steep. However, the subsequent flattening out of the forwards makes me believe the market is pricing the risk of somewhat elevated inflation, but not high-tail inflation.
Carl Bonde: In 2010, core inflation was running as low as 0.6% and many investors were worried about disinflation and deflation. During this deflation scare we had large flows of inflation floors going through the market. For example, on one side we had accounts buying floors to protect their equity portfolio and, on the other side, we had accounts willing to sell these as they were actually long them from their Tips portfolio and happy to sell them at rich valuations to pick up some extra yield. At this point, focus was very much on floors and deflation, but now with core inflation around 2% and loose monetary policy, deflation is not really a concern anymore. On the contrary, we are seeing investors starting to worry about high inflation and the effects of four-plus years of QE. And, on the back of this, we are seeing an increase in enquiries about high inflation protection either by buying high-strike caps or selling low-strike floors. As this market is still developing, we are seeing new customers entering the inflation space wanting to express their inflation views with options.
Mark Greenwood, Royal Bank of Scotland: Post-QE, there have been flows into Tips index funds by retail investors. But, across the market, retail notes in inflation are still down to about one-fifth of where they were last year. This is a function of much lower credit spreads on the debt, so a lower pick-up on the notes. Banks have also been buying back debt. We are running at 2.2% inflation, and it really needs to be higher than that to get retail investors interested. Returning to the options market, many notes pay leveraged collared inflation, and that takes dealers long caps. Dealers will cover short floors opportunistically, but they rarely sell caps as, in the back of their minds, they could always see the day when these would be in demand. There is a similar move away from fear of deflation towards inflation in the EUR and GBP options markets.
There are several clues we are getting from the options market. The first is skew, which is neutral. It used to be negatively skewed – in other words, towards richer floors and cheaper caps – but that has moved to neutral now. Given that dealers are structurally short floors, you might expect a negative skew. So the move to neutral, in my mind, is indicative of heightened inflation fears. Another cue comes from the index option market, where the correlations between the year-on-years embedded in index option volatility are now extremely high. The market is saying there is a high probability of successively high-inflation prints or successively low-inflation prints, but the old mean-reverting behaviour of the past five years is unlikely to persist.
The final evidence that perhaps inflation rather than deflation fears are predominating is the fact that, in early 2010, we alluded to some large trades to hedge deflation. At the time, ten years cost something in the region of 10bp running, and now they are only about 3bp running. Part of that reflects the fact that five-year, five-year is up at about 3%, so the forwards are so much higher. But, if somebody wanted that tail protection, it is relatively cheap and easy to engineer. It is the high strikes that are much more challenging.
Nikolay Stoyanov: I believe that the skew shape, until recently, was by and large the result of dealer positions, supply and demand, rather than any particular inflation views. Until not so long ago, the year-on-year volatility skew was quite negative, and the zero-coupon one was positive. If we look back, the vast majority of inflation-linked year-on-year notes issuance happened in 2004 and 2005, and was largely concentrated in the three- to ten-year sector. All of those notes had embedded deflation floors and a few, issued somewhat later, had a cap. The deflation floor embedded in the notes had little to do with perceived demand for deflation protection. The structure of those notes would simply require it. You can’t take money from the investor if the inflation-linked coupon prints negative. Certainly, you could design structured notes differently to avoid selling the floors, but those would be very clumsy and unappealing. In fact, the demand for the inflation-linked notes came from the relatively high realised inflation and inflation fears at the time. Further, if we look at the cash market, the five-year Tip then was pricing virtually worthless deflation floor.
The reckoning followed in 2008, when realised and forecasted inflation severely dropped and were negative for some time. Dealers were left with extremely illiquid short year-on-year floor positions and hugely expensive delta-hedging in the crisis. The push to rid those positions drove the skew negative even when forecasted inflation returned closer to normal. By now, most of those notes have matured or have been redeemed, which has driven the skew back to more normal levels. In the case of zero-coupon volatility, as already mentioned, the positive skew was driven by deflation floor supply from the Treasury via Tips despite the fact that most of the buying was probably of those floors rather than caps.
Risk: There has been considerable growth in Tips issuance over the past few years. Do you expect the growth to continue and has the Street reached its capacity?
Abhishek Nadamani: The Treasury will continue to increase the programme on a yearly basis. The $150 billion this year was a bit of a surprise, but the compression of asset-swap spreads and the auction results show there is definitely demand. In 2013, the Treasury will increase it by the same rate – a 15% increase on last year – I expect around $170 billion. Most of the increase will be in the five- and ten-year parts of the curve and the 30-year part will see the same supply. With five year and ten year, a lot of dealers and fast-money accounts can tactically trade around them, and you will see some demand, also from non-traditional accounts.
That being said, Tips just being 8% of the overall Treasury issuance doesn’t help the product. Tips should be a significantly greater percentage of outstanding issuance if the Treasury is serious about making this a deep and liquid market. If it remains this small, the market will continue to trade in a very illiquid and choppy fashion. We recommend Tips issuance of at least 25% of outstanding issuance as the market will be too big to ignore at that point and this will not just make a strong statement, but will also bring in other accounts that have thus far ignored Tips. The other side of this coin is that the Treasury will see very minimal upside issuing Tips here because breakevens are so low. It makes sense for them if breakevens are at 3% to increase issuance but, since the market is pricing so low, I see no upside.
David Mehl, Bank of America Merrill Lynch: $160–$165 billion is reasonable. We talked about how they could be doing some more in the five-year point, but they could also be doing some more in the ten year. We’ve seen ten-year breakevens perform really well throughout the year in comparison to the 30 year and 20 year.
Alvaro Mucida: I agree with those estimates, although I don’t discount the possibility that issuance in the long end could pick up as well. Even though most people agree the long end is relatively cheap – so tactically it might not seem to make sense to increase issuance in that sector – perhaps larger issue sizes could help the liquidity in the long end. Liquidity is one of the things the Treasury does care about – clearly it thinks long term, it doesn’t respond tactically to events in the market. If, on the one hand, by issuing Tips they capture the inflation risk premium, on the other hand, the liquidity problems make Tips trade with a liquidity discount. In terms of issuance costs, this liquidity discount is counterproductive. So, to the extent they can take actions that help improve liquidity in the marketplace, such actions would be helping reduce the liquidity discount, effectively lowering their issuance costs.
Risk: One of the more interesting flows over the past 12 months has been the forced unwind of Greek asset swaps. How did that play out and could you walk us through what happened?
David Mehl: This event was a serious shock to the global inflation market, which was extremely interesting to watch unfold from our perspective. It all started with the Greek private sector involvement.
There were a significant number of investors that owned these Greek bonds on asset swap and were effectively left short inflation swaps along with the nominal component as well. In general, they covered this inflation short by buying zero-coupon euro inflation swaps and, in doing so, pushed euro inflation swaps to very rich levels. The levels were so rich, in fact, that they became equal at some points on the curve to the levels of US inflation swaps, which closed a gap of about 40bp. As we’ve been saying, it was a very significant move.
This created a really interesting trading opportunity to buy US inflation swaps and short their EUR counterparts. After all, the macroeconomic situations in the two regions are and were substantially different and, thus, the inflation swaps trading at equal levels was not macroeconomically justifiable. So we were happy to advise accounts to put on these trades and, as they were put on, US inflation swaps richened significantly, their EUR counterparts cheapened and the basis between them widened back out. Since this flow was concentrated in swaps, the richening of US swaps outpaced that of Tips breakevens, which is what caused the significant cheapening of Tips asset swaps in January last year.
Risk: How do you think the market coped with that fairly
Karim Bendouma: It was surprising for the US Inflation market to see such a rapid movement, as Tips asset swaps cheapened tremendously when US CPI swaps richened during a couple of weeks in January 2012. But it created a tremendous opportunity for our clients and the market handled the move very well. At the time, Tips asset swaps were yielding 50bp more than Treasury asset swaps, even though both are issued by the US Treasury. You had investors coming in and looking at both investments and saying “why wouldn’t I buy a Tips asset swap and pick up an extra 50bp?” All of this created tremendous flows and brought more accounts to the asset class. Since then, we have been in a very bullish environment for Tips asset swaps. There is a great need for carry with interest rates so low, so every pullback in Tips asset swap prices has been used as an opportunity to buy, which was a welcome change since those kind of moves used to be signs of distress in the market.
Risk: Turning to discounting issues and multi-currency CSAs, what impact has it had on liquidity in the interdealer market?
Karim Bendouma: When you price a trade under a multi-currency CSA, there is optionality there. And modelling this is very difficult, especially for inflation trades, where most of the cashflows happen at the end when you get the principal back. So it creates issues for all markets, but probably more for the inflation market. When you have a multi-currency CSA, which rate do you use to discount the cashflows? It can depend on the forwards of the different currencies. CPI swaps are not affected because they are zero coupons, but long-dated Tips assets swaps have suffered from it. The impact on options is fairly small and the market can easily deal with this by using forward premium payments in the case of zero-coupon options or running premium payments for year-on-year options
Alvaro Mucida: This issue has made liquidity in the long end more challenging, and that’s unfortunate for clients interested in that sector. Many European pension funds, asset managers and insurance companies, for example, who are used to the UK retail prices index market and who trade 30- or even 50-year inflation swaps cannot get the same kind of liquidity in long-dated Tips asset swaps.
An interesting development in the inflation market over the past year has been the emergence of electronic broker platforms, which helped liquidity in most inflation products but, because the price of an asset swap is dependent on the counterparty and one cannot know the counterparty in advance on these platforms, Tips asset swaps don’t really trade there, except for the really short-dated ones.
Now, single-currency CSAs would be a solution, but it is not a simple one to implement. Clearing may be the way forward, but it is going to take some time.
Risk: How has the market adapted? Is this where the basis trading volumes came from?
Abhishek Nadamani: The biggest drawback of the multi-currency CSA is the lack of asset-swap trading in the interdealer market. Most of the asset swaps we trade these days in the interdealer market are at the very front end, where it is purely a funding trade, so the CSA doesn’t really matter. In the sub-five-year sector, the CSA impact is at a minimum, but the long asset swaps haven’t traded in quite a while. The flip side is we have started trading a new instrument called the basis, which at least provides some sort of liquidity for the market. The biggest worry is that asset-swap trading will now concentrate on very specific bonds because, if you look at low-index Tips such as the July 2016, there is no ‘correct’ asset-swap price for that. It depends on which counterparty you are facing and it doesn’t make for a cohesive market.
For the dollar product, we have to discount on a dollar CSA. It makes no sense to have different CSAs with different counterparties, and the only solution is to have a common CSA among all counterparties trading the dollar product or to move to central clearing, which has the same end-effect.
Mark Greenwood: Having multi-currency CSAs between banks makes novations difficult, and that doesn’t help market liquidity or price discovery for end-users. When a dealer is asked to step into a trade and face another unknown CSA, they will have hedging costs and a different present value. This is difficult for end-users to accept in what should be a fungible product. So, that in itself should be a reason why we will all ultimately benefit from having a standard CSA.
Isda has a draft of a standard CSA, one that will interface more with collateral terms on an exchange. Looking on the bright side, there has been a much bigger appreciation of overnight indexed swap (OIS) basis and cross-currency basis with regular OIS curve trades out to 50 years to hedge discounting of inflation zero-coupon cashflows.
Risk: Under Basel III, more capital is needed for longer-dated, uncollateralised trades. Some firms have been using pay-as-you-go structures to mitigate some of that impact, but are there other ways to do the same kind of thing?
Mark Greenwood: That has been a solution in the UK for unsecured trades, but different solutions may be required in the US and Europe and for secured trades . The credit valuation adjustment (CVA) capital charge is often the major driver of the Basel III capital requirements. There has been a lot of progress in modelling that, both for secured and unsecured trades.
Risk: Do you spend more time thinking about CVA and other adjustments than you used to?
Carl Bonde: Yes – the kind of collateral you post to your clients and what CSA agreements you possess have become very important. That has been a focus of the past couple of years at Citi. We have a desk that takes care of most of the CVA calculations. If we get a new counterparty and it is uncollateralised, then we hand it over and the CVA desk will take that risk from us, which is great.
Risk: Some firms – notably UBS – have decided that the fixed-income business is too capital-intensive. Will there be a reduction in the number of players in inflation over the next couple of years, and what does that mean for the dealers that remain?
Robert Tzucker: There are a couple of things we can point to here. It certainly can be a capital-intensive business. It makes it very difficult to do trades with corporate entities if they want to hedge inflation and it is not a counterparty with which you would normally have a CSA. It adds to your risk-weighted assets in an enormous manner and it makes it far too expensive to do because you can’t make it profitable enough to offset the capital costs. That is one place where there is possibly a negative.
I think all banks are doing the same kind of analysis as UBS, but Credit Suisse came to a different conclusion in that, when you look at inflation particularly, it has been a growth area, and there is still commitment across the Street to improve and grow this product. When you look at the BGC volumes, we are up again this year. But I don’t think the interdealer volumes are telling the whole story, because we have seen a broad growth in customers, and sometimes you can see both sides of a trade. For example, in 30 years, the asset swaps may not be trading in the broker markets as much, but there are people who will buy 30-year inflation swaps and you can sell 30-year asset swaps to certain customers and be able to offset those kinds of flows.
Will it be easier to turn a profit? I don’t think it will ever be easy to turn a profit. As volumes grow, it makes it a little bit easier, but bid/offers get tighter so you are always scrapping to find the next trade, and everybody in this room competes with one another every day, so it is never going to be easy. But the growth of this product continually makes it a little easier to hedge in the interdealer market. It’s just how you hedge now with all the things that we have been talking about – the different CSAs – that create some challenges. But, as we develop things like single-currency CSAs or clearing, all those issues go away. It is going to take a bit of time but, until then, I think we all just manage – if we have to show Tips versus swaps, then we do that. We are going to adapt and develop.
David Mehl: There are forces at odds here. The business is capital-intensive, but we will find a way to make it work because the business is growing and growth solves a lot of problems. Also, inflation has become a very important part of the fixed-income franchise of a bank. I don’t think participants will leave the market. Maybe it will deter other would-be entrants from coming in, but I don’t think this will decrease liquidity. As we’ve all mentioned during this discussion, client activity has continued to increase this year, which certainly serves to bolster liquidity in the market. Furthermore, a consolidation among dealers will not necessarily reduce liquidity; an increased number of client transactions with a more concentrated group of dealers has the potential to actually increase liquidity.
Risk: What do you expect from the next 12 months?
Mark Greenwood: The US inflation market doesn’t suffer from some of the problems regarding revisions to the methodology of the index that we have in the UK. It doesn’t have the redenomination risk of inflation trades like you do in Europe. So it has a good basis from which to develop. Notes will remain vanilla but, if and when we again get a 3% inflation print, there is no doubt the market will take off. Hopefully, we will see some more exotic instruments emerge, even if they have plain-vanilla payoffs like callables, which will then allow the market to develop along the lines of inflation swaptions, index options and year-on-year options.
Robert Tzucker: I expect that real-money accounts are going to be more and more involved, using inflation swaps particularly as tactical instruments. That has helped balance the market to some degree. Real-money accounts have typically been sellers of inflation because they have a hard time going short anything in their portfolios, but off-benchmark plays – the swaps, forwards space – are really nice because, in the forwards space, you don’t have to deal so much with seasonality. As inflation goes up, they are going to try and protect themselves against duration moves, so duration shortening and inflation longs are probably going to continue to be the theme.
Abhishek Nadamani: It will be a very vibrant market. We are in a really unique situation right now. In this low-volatility, “everything is known for the next five years” market, there are a lot of non-traditional accounts with excess capital on the sidelines and eager for returns. The stock market refuses to move, nominal interest rates are stuck, so inflation is the next place where things are actually mispriced. This opens the door for a lot of investors that need to make returns, and we’ll see a lot of players come in who will just want to play front-end Tips, front-end asset swaps, collect the carry and sell volatility.
Nikolay Stoyanov: I also expect the real-money client base to continue to grow. In the past, more often than not, implied inflation, front end especially, has traded cheap relative to realised inflation. With new money coming into the asset class, I expect that to occur less. I expect the derivatives market to pick up as well. The basis between the inflation swaps and cash breakevens has been very stable and has narrowed significantly. I don’t expect it to widen back out much, if at all, as the demand for extra yield will keep a bid on the Tips on asset swaps. Stable and narrow basis implies the inflation swaps levels are comparable and bid/offer spreads will nudge closer to those of cash breakevens, so they will represent a viable alternative to the cash market. For inflation forward or spread trades, the swaps market is a great alternative, because, in cash, those trades are very balance-sheet intensive. However, the big new unknown for the inflation derivatives market is how it will respond to the new impending regulations, namely Frank-Dodd and Basel III.
David Mehl: No matter what path inflation takes for the next year or several years, there will be increased tension surrounding it. In the US we are seeing politicians, economists and the media talk about inflation more now than they have since the 1970s. I don’t think that is going to stop until we get to the end of this QE initiative the Fed has embarked on, and I don’t think we are very close to the end of that.
We have all mentioned that we have seen non-traditional players continue to enter into the market this year. I think we will continue to see that. For example, players that aren’t interested in nominal swaps or other rates products will want to take a view on US inflation. Conversely, equity or corporate bond portfolio managers may realise they have inflation exposure depending on what names they own, they then may enter our market to hedge their existing exposure. Also, we have a lot of investment products in this country that are linked to real rates. We have some that are linked to inflation, but they are disproportionately linked to real rates. There is a good opportunity to create products for investors that are linked to inflation. It now comes through certain insurance contacts and there are already retail investment products, but it is a significant area for growth, which would certainly feed its way through to our market. Also, in general, we have seen an increase in the number of contracts brought to us that have to do with real estate, land purchases or large asset purchases linked to inflation, and that is just one more area in which inflation exposure exists, which may or may not be hedged out.
Karim Bendouma: The dislocations we are seeing will slowly go away, whether it is Tips, asset swaps or inflation volatility. It has been a slow grind, with asset swaps slowly richening from the extreme levels of 2008, and implied volatility slowly going down in the same period. The Fed is probably not doing enough in the US, so it will do more – we may have more QE, but probably not in the same format as we know now. Everybody is exposed to inflation; we’ll see more customers coming to the asset class. In Europe, real yields are seen as another asset class. In the US, it is slowly getting there, so it is going to bring more accounts trading the product.
We are going to see some new developments, probably trading some new indexes and custom trades. We get a lot of enquiries about medical inflation and core inflation, for instance, so we’ve developed an index to trade core inflation. We’ll see more of those developments, and we’ll see more demand for structured trades with good carry. Inflation swaptions are not trading yet but there is no doubt that this is the next step for the option market.
Carl Bonde: This year will probably be a continuation of last year, with more accounts getting involved in the inflation derivatives business, such as real-money active in Tips, but not yet in derivatives and corporate accounts that need to hedge inflation exposures. The inflation market has come a long way since the first Tips were issued in 1997, but there is still a long way to go. There are some great opportunities in inflation, be it carry trades or dislocations, but these will eventually disappear. However, at the moment, I think highlighting these opportunities to our clients is a great way to increase the customer base and get more clients involved.
Alvaro Mucida: We are going to get to an end-game on the fiscal cliff and, hopefully, we are going to get more clarity around Europe. We have geopolitical risks that affect our market, particularly through energy, and I don’t expect them to go away anytime soon. This uncertainty is positive for our market to a certain extent, as it generates demand for hedging. In the market right now, there are genuinely opposing views because of the open-ended QE and the debate as to whether monetary policy can generate inflation or not. I don’t expect inflation to start printing higher in the next 12 months but if we do start to see more consistent signs of economic recovery, then the debate is going to get a lot more heated.
In terms of products, an interesting development – perhaps not relevant for all investors but certainly for fast money – is trading of the CPI fixings. That has picked up quite a lot recently. Hedge funds have been getting involved, and perhaps other types of accounts will, too. And then, who knows? More exotics – swaptions and Tiptions – may appear.
D’Arcy Miell: The market continues to evolve, with traders keen to develop products that will help provide liquidity to clients. The more traders supporting the market, the faster the market will mature. I see the derivatives market growing in line with the Tips market, perhaps at the same levels as 2012 .
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Topics: Federal Reserve, Deflation, Deutsche Bank, Barclays, Citi, JP Morgan, Credit Suisse, BNP Paribas, Basel III, Volatility skew, Consumer price index (CPI), Bank of America Merrill Lynch (BAML), BGC Partners, US inflation options, Treasury Inflation-Protected Securities (Tips), Royal Bank of Scotland (RBS), Quantitative easing (QE), Regulation, Inflation TIPs, Skew, Credit valuation adjustment (CVA), Year-on-year inflation, Liquidity, Credit support annex (CSA), Dodd-Frank Act, Overnight indexed swap (OIS), Asset swaps, International Swaps and Derivatives Association (Isda)
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