Protection on long-term deflation hits highest levels since 2008

Hedge funds seeking protection against deflation and dealer hedging of residual short floor positions are cited as the reasons for a rise in prices on euro zero-coupon inflation options.

The cost of option protection against long-term deflation in the eurozone has reached its highest levels since late 2008.

Traders suggest a number of reasons for the surge in prices of 10-year euro zero-coupon 0% floors - from hedge funds and pension funds insulating themselves against the risk of deflation, to dealers hedging short year-on-year floor positions. The move comes amid falling inflation breakevens (the difference between nominal and real yields), heightened market volatility and general uncertainty in the markets.

"It is a question of probabilities. The decade of deflation in Japan followed a property bubble, stock market crash and high government deficits, which maybe isn't so different to what we're seeing today in many markets. I'm not saying we're exactly in the Japan scenario, but there are elements that are creating concerns for some people, and therefore it's reasonable to price in some of those concerns," says Dariush Mirfendereski, global head of inflation-linked trading at UBS in London.

Ten-year euro zero-coupon 0% floors - or inflation index options - are trading at 70 cents of upfront margin, dealers say, compared with 20-25 cents of upfront margin in January this year.

However, dealers say it is unlikely to be a demand squeeze that is pushing prices higher. The popularity of asset swaps on inflation-linked government bonds has meant there is ample supply of zero-coupon options in the market. Whenever an investor trades a linker asset swap, dealers are left with a long position in these options.

"There is a healthy supply and two-way flow of 0% inflation index floors. Price discovery and recent trading levels indicate these options are pushing higher and higher in price. You could argue this price surge - despite the available supply - is driven by the increased market volatility and the greater recognition that you can have gap events like Lehman Brothers, with which the whole breakeven market can collapse," says Mirfendereski.

Prices have not reached these levels since October 2008, when dealers scrambled to hedge 0% year-on-year inflation options that had been embedded into structured notes. In proceeding years, these floors had been sold by banks for almost nothing as the risk of deflation was considered extremely remote.

However, as inflation expectations dropped in the wake of Lehman's collapse, these floors soared in value, sending banks rushing to hedge their short exposures. With most dealers all positioned the same way, and with little supply, the price of options soared, peaking at around 70 cents of upfront margin.

As central banks pumped liquidity into the system, volatility fell and deflationary fears eased over 2009. However, concern about deflation is growing once again, with a succession of eurozone countries announcing austerity packages to help tackle gaping deficits. Volatility has also picked up, causing concern for those dealers with residual short option positions, as well as other investors worried about deflation.

"The Street is short year-on-year 0% floors. When breakevens are on the rise, nobody cares about these short positions. All of a sudden, the market is distressed and breakevens are plunging, austerity packages are promoted everywhere, and people think maybe deflation is not such an unlikely scenario and start getting hedged. I think the risk appetite between now and the first two months of the year has massively reduced," says one London-based inflation trader.

Several participants speculate some dealers might be attempting to cover legacy short positions on year-on-year floors using zero-coupon options. Others point out 10-year index inflation options are an imperfect hedge for year-on-year floors, and believe the activity is client-driven.

"We certainly have seen interest from hedge funds. Some might be happy to follow strategies where they lose out when the world is normal to protect themselves and generate cash when the world is abnormal. The market has come through the credit crisis, we're now in the middle of a sovereign crisis, and uncertainty has never been higher. That said, the market is overpricing this uncertainty for technical reasons: there's been a strong buying interest, and volatility is rising because breakevens are coming down," says Daragh McDevitt, global head of inflation structuring at Deutsche Bank in London.

Mark Greenwood, head of inflation options trading at Royal Bank of Scotland in London, agrees at least some of the move could be explained by hedge funds looking to protect themselves against deflation.

"A hedge fund might look to spend €20 million to buy very far out-of-the-money protection against European deflation - this might be cheap tail risk hedging for them. They might be happy to write off this €20 million, knowing that if we do get sucked into a deflation spiral, then €4 billion of floors will pay off handsomely and they will outperform competitors. These 10-year 0% zero-coupon floors are the one hedge a fund can put on in size as there is a healthy supply from asset swaps. From this perspective, it is not necessarily such a bad trade," he says.

Dealers estimate around €5 billion of zero-coupon options have traded in recent months. However, opinion on the likelihood of deflation is not all one way. Some still believe the economic stimulus measures implemented by central banks around the globe last year will eventually feed through to higher inflation. The result is a high level of uncertainty, leading to increased volatility.

"There is clearly a lot of worry in the current environment, so markets are likely to remain choppy and it is difficult to predict what's going to happen in the short term," says Benoit Chriqui, head of European inflation trading at Barclays Capital in London.