No chance of price declines – say traders

The cost to hedge against the Consumer Price Index declining has dropped to a new low, indicating that markets expect prices to keep on rising.

Financial innovation is a wonderful thing. The acceleration in the evolution of financial futures and options during the 1970s and 1980s undoubtedly helped to make hedging risk much easier and more flexible. More and more complex derivatives have appeared since then, including so-called inflation derivatives, which are designed to help people take a view on the future course of a consumer price index. I came across this paper listing a mind-boggling array of different types of inflation derivatives including zero-coupon inflation swaps, spread options, swaptions, caps, floors, inflation-linked credit default swaps and inflation-linked credit default obligations. The paper is from Lehman Brothers, dated 2005, which tells a story in itself! Nevertheless, some of these derivatives survive and thrive today, including the inflation-indexed floor.

An inflation-indexed floor provides a profit to the buyer if the percentage year-on-year change in the Consumer Price Index (CPI) drops below a certain level over a specified period of time. A buyer of a 5-year inflation floor at a strike price of 1% would benefit if the rate-of-change in the CPI fell below 1% over the next five years. Being essentially a hedge against a declining CPI, the price of inflation-indexed floors reflects the market’s view on the probability of declining prices.

The chart above shows the price of the US dollar Inflation Floor 0% 1-year. It therefore shows the cost to hedge against the annual change in CPI moving below 0% over the next year. As we can see, the price has made a new low, indicating that the market thinks there is a hardly any chance of CPI moving below 0% over the next year.

With CPI currently at 1.9%, that pricing may appear to be sensible for this short tenor. However, longer-dated inflation floors, although not at such an extreme, also show that the market thinks declining CPI is a relatively low probability. Indeed, the pricing for the 1-year floor is a reflection of extreme sentiment and when it has reached extremes like this before, it has been followed by a swift re-appraisal.

This chart shows the Inflation Floor along with the US Treasury 2-Year Breakeven Rate. This is the yield difference between a nominal bond and an inflation (CPI)-protected bond, reflecting the market’s expectation of CPI. In 2011 and in 2014, when the floor had reached these levels before, the breakeven rate subsequently fell sharply.

In other words, the market’s expectation of CPI started to decline when hardly anyone expected it to. With sentiment yet again skewed one way, there is a good chance that investors’ CPI expectations will start to decline again as well.