Inflated or deflated?

With rising inflation making headlines around the globe, inflation derivatives dealers are seeing trading volumes pick up, but report surprisingly subdued interest from new investors looking to hedge their liabilities. Peter Madigan reports

As the credit crisis rumbles on, inflation has announced itself as the next major concern for central bankers across the globe. According to figures from the US Bureau of Labour Statistics, annual inflation in the US, as measured by the headline consumer price index (CPI), hit 4.2% in May. It's the same picture across the Atlantic. In the UK, the retail prices index (RPI) climbed to 4.3% in May, up from 4.2% in April, while the harmonised index of consumer prices for the 27 countries of the European Union reached 3.9% in May versus 3.6% in April.

International inflationary pressures stem not only from soaring oil prices, which breached $140 a barrel on June 26, but also from a variety of more mundane items. The UK's Office for National Statistics identified goods ranging from meat, fruit and vegetables, to newspapers, foreign holidays and even household cleaning products as contributing to rising prices.

Despite the re-emergence of inflation, central banks have so far been reluctant to raise rates, deterred by weak housing markets in the wake of the subprime mortgage crisis. In fact, the US Federal Reserve has slashed rates seven times since September 2007, taking the federal funds rate from 5.25% to 2%, while the Bank of England has trimmed base rates by 75 basis points since July last year. The European Central Bank (ECB), meanwhile, has left rates unchanged at 4% since June 2007.

This now looks set to change. Analysts are confident interest rates in Europe will rise after ECB president Jean-Claude Trichet's June 5 admission that he was not excluding the possibility rates could go up "a small amount" at the next meeting this month. This was followed just five days later by Fed chairman Ben Bernanke's vow that "the Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations", triggered by rising energy prices.

It is hard to imagine a richer environment for inflation traders to harvest new business as stories bemoaning the worsening inflationary prospects spill out of the business pages into the personal finance columns. Notwithstanding the tough talk from central banks promising swift action to bring prices rises under control, the conditions necessary for inflation trading to prosper could hardly be better, with both the ECB and the Fed continuing to provide abundant liquidity facilities to banks to help them work through the credit crisis.

Despite the fertile conditions, however, inflation-linked bonds and derivatives have not been trading in the volumes that might be expected. Dealers report that while inflation trading volumes have increased overall as institutions look to put on inflation hedges, activity has remained patchy, with few new investors accessing the asset class.

In part, trading has been constrained by a shortage of inflation supply, at least in the UK. In March, the Debt Management Office (DMO), the entity responsible for issuing UK government bonds, announced it was raising its issuance of index-linked gilts to £18 billion for 2008, a slight increase from £17.2 billion issued in 2006. To put that figure in context, however, it represents less than a quarter of the £80 billion in gilt issuance the DMO plans for 2008. Corporate supply, meanwhile, has virtually dried up, partly in response to the travails affecting the monoline insurance sector - used to wrap for the vast majority of corporate inflation-linked issuance from UK utilities and private finance initiatives in recent years (see pages 44-45).

On the other side of the coin, demand for inflation from pension funds remains strong. Under UK accounting rules, pension funds are required to calculate liabilities using a discount rate based on AA-rated corporate bond yields. Under pressure from the UK Pensions Regulator to match assets and liabilities, pension funds have poured into inflation-linked bonds and swaps, pushing up the cost of inflation protection.

Ten-year breakevens on UK gilts - the spread between nominal yields and real yields, reflecting expected inflation plus a risk premium - have steadily climbed over the past six months, rising from a low of 313bp on January 7 to 403bp by June 17. Ten-year inflation swaps, meanwhile, started the year at a low of 3.10% on January 7 before appreciating steadily through the first half of 2008 to reach 3.66% on June 17.

"The UK inflation market is driven by end-user flow rather than by inflation expectations. Normally, there is a balance between supply from corporates with real assets and demand from pension funds, but at present inflation is trading very high because there is very little corporate supply," explains Benoit Chriqui, head of European inflation trading at Barclays Capital in London. "That's because in recent years most of this supply was straight inflation-linked issuance, wrapped by monolines, then sold to asset swap buyers. Because of the current monoline difficulties and lack of appetite from credit investors, that route is no longer effective, so we've had a lack of inflation supply since August last year."

The entire UK gilt market is itself dwarfed by the $470 billion US Treasury inflation protected securities (Tips) market, by far the biggest and most liquid market for inflation-linked government bonds in the world - although still just a small portion of the $4.4 trillion US Treasury market overall.

In a period of strong upward inflationary pressure, US investors could be expected to try to hedge their portfolio against inflation by gaining exposure to the Tips market. While dealers report this has occurred since the start of the year to a certain extent, uptake has been less than stellar. In particular, traders note a number of hedge fund investors ditched Tips positions, as part of a more general unwinding of exposures after the near-collapse of Bear Stearns in March.

"This year, Tips trading volumes have picked up in general, but it tends to ebb and flow. We've had some periods of relatively inert trading, but the Tips market was very active in April when we had lots of inflation supply in the market," explains Com Crocker, director of Tips trading at BNP Paribas in New York. "In late March, highly leveraged hedge funds liquidated their Tips positions following the lower than expected February CPI data and the Bear Stearns purchase. That large deleveraging took the Tips market to extremely low levels, but we've seen plenty of money coming into the market since, with the market being particularly active through supply in April and again since early June."

Ten-year Tips breakevens increased from 233bp at the start of the year to reach 256bp on March 7. Following the near-collapse and subsequent acquisition of Bear Stearns, breakevens plunged to 227bp on March 17. They have since climbed back to 251bp as of June 17 (see figure 1). However, this is out of sync with headline inflation - the breakeven rate on June 17 was 169bp below the May CPI rate of 4.2%. By way of comparison, in August 2006, with CPI at a comparatively low 3.2%, 10-year Tips breakevens hit a two-year high of 266bp.

Does this indicate that inflation desks consider 2.5% to be a closer reflection of future inflation? Dealers say this is not necessarily the case, arguing that supply/demand imbalances have played a part.

"Inflation markets are not as pure from the practical side as they are in theory, so deriving any solid market expectation from breakevens does not take into account the myriad factors that influence where prices are trading. In the current thin trading environment with lower liquidity, the market is far more influenced by imbalances between inflation supply and demand and by investors such as hedge funds pulling out of positions. So it's misleading to think of this data as market expectation rather than simply as the price at which business is being done," says Jasper Falk, head of inflation trading at JP Morgan in London.

While the UK, along with parts of Europe, has seen strong demand for inflation from pension funds and other liability-driven investment strategies, the dynamic does not exist to the same extent in the US. In recent years, changes have been made to US accounting rules, requiring firms to recognise the funded status of defined benefit plans in their financial statements (Risk April 2008, pages 72-74), but this has not yet translated into strong use of inflation-linked bonds and swaps. That may change, however.

"US insurance companies have been looking to link annuities to inflation, but the problem has been that end-user demand has always been sketchy because clients hate the idea of accepting a lower rate of return than on nominal Treasury bonds - despite the fact they get inflation on top of that," says BNP's Crocker. "This is true of Tips in general. People are put off by what appears to be a low or in some cases even a negative yield and would rather buy a nominal bond, even when the breakeven is lower than it should be, since it still shows a positive yield upon maturity."

Dealers report increased interest in total return swaps on Tips and CPI swaps from hedge funds and some real-money investors in the US - although, like Tips trading, activity has been erratic. In a manner similar to 10-year Tips breakevens, 10-year US inflation swaps moved steadily upward from a 2008 low of 2.59% in mid-January to peak at 3.14% on March 11 before plunging during the Bear Stearns episode as the same leveraged hedge funds fleeing Tips also sought to unwind their inflation swaps (see figure 2). A muted, if rocky, recovery has taken place in the months since, with rates oscillating throughout April before climbing to reach 2.99% by June 17.

However, while activity in swaps and index-linked bonds has at times been subdued, dealers report increased interest in trading inflation options. A relatively active interdealer market for inflation caps and floors has existed in Europe for more than a year, driven in part by the inflation-linked structured products market. With inflation rising, there has been strong interest to go long inflation volatility through options in recent months, both directly and via structured products (see pages 46-48).

"We've seen more inflation caps and floors trading because many investors have been surprised with how volatile inflation has been. Previously, received wisdom was that central banks could be effective at targeting and containing inflation, and end-users did not view an inflation breakout as a real risk. Today, there is much more uncertainty over inflation volatility and the ability of central banks to keep inflation in check. There has been an increased interest to hedge against further upside movements and inflation caps are seeing new demand as a way to counter near-term inflation spikes," says Chris Lupoli, an inflation-linked strategist at UBS in London.

Options have been slower to take off in the US - although dealers report there has been a pick-up in interest from hedge funds, in particular, to trade inflation caps. "Caps and floors are a more natural trade for players that are in the market regularly, since on both sides of the trade the buyer and the seller can limit their inflation liabilities at either end," says Keith Morris, senior government bond trader at JP Morgan in New York. "For the leveraged community, buying Tips and keeping them on balance sheet is a big issue, so caps and floors present a way to take inflation exposure off balance sheet and provide a lot more room to manoeuvre."

But despite the recent prominence of inflation, both on the agenda at meetings of central bankers and in the media, little has changed for dealers. The notion of a sudden large-scale rush into inflation by investors that have suddenly awoken to pre-existing inflation liabilities is one that traders don't regard as feasible. In fact, while tremendous potential for growth exists in the US, the consensus in the UK, and to a lesser extent in Europe, is that many of the institutional players most likely to venture into inflation are already active in the market.

"The fact that inflation is currently running at high levels is likely to generate extra retail interest, but for end-users with inflation liabilities who have probably already been executing hedges at cheaper levels, it is unclear they will look to increase their hedging now that levels are more expensive," says Barclays Capital's Chriqui. "The markets have developed significantly in the past three or four years, so those with exposures are probably already involved. Just because inflation is in the news, it doesn't mean investors are suddenly more likely to get involved."

See also:

• BIS chief points to central banks and warns of inflation risk

• Price concerns spark inflation activity