Matching eurozone country-specific inflation demand with supply has long been tricky for investment banks. While some dealers claim to have always looked to line up buyers and sellers on each trade, thereby running books that are more or less flat, big market-makers in domestic European inflation have traditionally only been able to offer liquidity across the country-specific inflation curves by retaining some risk on their balance sheets.
That is largely a function of the size of the markets. Domestic European inflation markets are a fraction of the scale of the overall euro inflation sector, meaning it is far more difficult to source supply and simultaneously find buyers to take the other side. “The volumes in the domestic eurozone inflation indexes are less than 5% of the European index market,” says Jasper Falk, London-based head of inflation trading at JP Morgan.
Before the financial crisis kicked in, dealers would take country-specific eurozone inflation risk on to their books when it was available, with supply usually coming from infrastructure-related private finance initiatives (PFIs), utilities or real estate groups that have revenues linked to inflation. Banks would partially hedge their book via swaps on the much more liquid European harmonised index of consumer prices ex-tobacco (HICPx) and live with the basis risk. They would then look to reduce country-specific risk when buyers were in the market for it.
Pension funds pursuing liability-driven investment strategies are big buyers of inflation when it can be tailored to precisely match their liabilities, while hedge funds would at times come in on the offer side. The problem is lining up both sides of the trade at the same time. As a result, banks could end up holding the risk for some time.
“Banks are there to warehouse the supply flows and then to go out and convince domestic pension funds to hedge the exposure they have to their domestic inflation,” says Stéphane Salas, global head of inflation trading at Société Générale Corporate and Investment Banking (SG CIB) in Paris. “All these PFI-related projects have to hedge, and therefore jumbo trades on these domestic illiquid indexes come to the market from time to time. That gives a large supply of inflation – usually, the projects have a stream of revenue all the way to 30 years. But in terms of timing, it is difficult to match that supply with demand.”
The inflation risk was therefore recycled into the market gradually, with banks intermediating to break down the mismatches between buyers and sellers of inflation – in terms of timing, maturity and type of payout. “When you do one of these trades on an illiquid eurozone index, you generally hedge with European inflation straight away,” says Ricky Varaden, a London-based inflation trader at Royal Bank of Scotland (RBS) who specialises in illiquid indexes. “You eliminate the outright risk, so you just have the spread risk to manage. Then, you get out of the spread risk as and when the opportunity arises.”
That model appeared to work until Lehman Brothers went bust in September 2008. In the subsequent turmoil, bank balance-sheet capacity and risk appetite shrank markedly, while hedge funds withdrew from the market, having racked up hefty losses elsewhere. At the same time, non-government supply of inflation dried up and liability-driven investors sat on the fence, creating a severe liquidity drought in domestic inflation markets.
This year has seen something of a reversal, however. Dealers say liquidity in European inflation markets has picked up markedly over the past few months, as end-users look to match inflation hedges as closely as possible to their exposures. “Many corporates, financial institutions and government agencies, for regulatory or accounting reasons, either prefer or are constrained to hedge their inflation exposures with the local index that will best match their exposures rather than the HICPx, which is more liquid but which would result in them holding the basis risk between the two indexes,” says Varaden.
RBS reports that liquidity in general in the domestic European and Scandinavian indexes has increased dramatically since the start of the year, to levels comparable with the market pre-Lehman. “This year we are starting to see bigger tickets printed in indexes that previously traded infrequently and in limited size,” says Varaden. A total of Skr500 million ($69.6 million) of 10-year and 15-year inflation swaps traded in Sweden in one week in April – more than the amount traded in the whole of 2009, according to RBS. Five-year, seven-year and 10-year Danish inflation also traded in the market in March this year, compared with only a couple of trades on the Danish index in the interbank market in 2009.
“There is going to be more and more interest from end-users to focus on domestic rather than European inflation, given that is what they are actually exposed to, and that’s going to bring the market back,” says Benoit Chriqui, head of European inflation trading at Barclays Capital in London. “Once we have some flow then the market can re-establish itself – not necessarily around fair value given the interest might not be two-sided, but bid-offers will come down, which will help bring more flow.”
However, while there is more interest in domestic inflation, there is a continued lack of supply. Issuance of government inflation-linked bonds is insufficient to meet demand, while infrastructure projects are patchy, with local municipalities and construction firms only gradually recovering from the slump. This lack of balance has contributed to the domestic indexes fixing above European inflation this year, creating mark-to-market gains for those sitting on long domestic inflation positions.
“Many of these indexes have fixed above HICPx for several months now, so dealers long these indexes enjoy a positive carry,” says Varaden.
Like its peers, RBS anticipates greater client interest in inflation hedging this year, with end-users switching to domestic inflation indexes when the opportunity arises. “They will do this by tactically hedging themselves with HICPx, then gradually switching into the domestic index as and when pockets of liquidity allow this to happen,” says Varaden. “This will be the case until we see increased supply through project finance deals, utilities, real estate or even government issuance. If that comes, it will balance out the demand for these indexes, which will then result in liquidity as never seen before in these markets.”
However, while there is growing interest in domestic inflation markets, problems remain. In particular, it is still difficult to perfectly and simultaneously line up both sides of a trade on domestic inflation. That is made more problematic by the fact not everyone active in the market pre-crisis has returned. Although some dealers report small amounts of trading from relative-value accounts, most say there has been little activity from hedge funds this year.
At the same time, banks are now less willing to warehouse risk for long periods. “Before the crisis, banks in general were relatively happy to warehouse the spread risk, sometimes without specific plans as to what to do with it in the short term. But since September 2008, with value-at-risk and capital usage under more scrutiny, dealers have found themselves limited to pockets of liquidity and only warehouse risk if they are able to demonstrate a strong track record of two-way flow in the respective markets,” says Varaden.
This is partly driven by new regulations. Revisions to Basel II will require banks to hold higher levels of capital for risk on their books, and there is greater awareness of liquidity risk, counterparty risk and credit pricing. At the same time, banks are a lot more cognisant of balance-sheet usage – factors that, in combination, are likely to act as a constraint on the growth of the market.
“Banks will be more systematic in terms of trying to manage supply and demand, and more systematic in warehousing less risk. And as they will be more risk averse, then prices are going to be wider,” says SG CIB’s Salas.
Chriqui of Barclays Capital agrees banks are less willing to warehouse risk, particularly as many of the correlations between the various markets have broken down. “All the elements of the inflation curve that used to be warehoused against each other have de-correlated, so even if a bank had the same appetite to warehouse the risk, it would be less efficient now to do so,” he says.
In fact, many of the assumptions used when pricing and risk managing local inflation markets are in flux. For example, before the financial crisis, Spanish inflation generally traded at between 50 basis points and 100bp above European inflation. That observed stability was a good starting point for pricing the domestic Spanish index, but no longer exists. “With the crunch, we’ve seen an inversion of those spreads and people have realised the assumptions they made in the past in terms of the behaviour of the basis were flawed,” says Salas.
As a result, dealers and risk managers are much more wary about entering into trades with no clear idea of how to lay off the exposure. “You only warehouse something when you have an understanding of how long you’re going to have it on your books for. If you don’t see a prospect of selling it, then you don’t do the trade,” says JP Morgan’s Falk. “Before the financial crisis, the assumption with a lot of these countries was that the market expected them to have significantly higher inflation levels than the rest of the eurozone. The crisis turned that on its head. There turned out to be negative inflation levels, certainly in Ireland and Spain.”
The divergence between the HICPx and the domestic inflation indexes means those using the European benchmark as a hedge have to focus carefully on how they manage basis risk. This is perhaps less of an issue for the larger eurozone countries – the predominance of German and Italian inflation in the HICPx means the European index is not a bad interim hedge for these domestic inflation risks. For smaller countries with less weight in the index, however, the HICPx has always been a less than precise hedge.
“If you look at the basket of the HICPx, it is made up of all the different country contributions weighted by the household consumption expenditure, so predominantly that’s Germany, France and Italy,” says Dariush Mirfendereski, head of inflation-linked trading at UBS in London.
Activity in domestic European inflation markets has certainly picked up this year, helped by growing demand for local inflation hedges by a variety of end-users. However, the perennial difficulty in matching demand with supply remains. Since the crisis, dealers are much more wary about warehousing exposures and waiting for the other side of the trade to emerge. Pockets of supply do exist, but the trick for dealers is leveraging off relationships to line up both sides of the trade at the same time – something that may hinder growth in the short term.