Europe and the US have grown accustomed to the benign macro economic environment that has prevailed for much of the early part of this century. Double digit inflation and interest rates are a distant memory for many, while many in the West have never even experienced it.
At the same time, the market for inflation products is relatively young and illiquid. Participants in the market are vulnerable to structural basis risk because their exposures have typically been hedged with inflation-linked bonds. Rapid unwinding of positions can cause market dislocations.
The Lehman factor
Since mid-September the inflation market has experienced dramatic dislocations, and around the world breakeven inflation rates have nosedived, in many places wiping out a year’s worth of advances in two weeks.
Japan has seen the most spectacular collapse, and the situation there is unique. Up to 80% of the inflation products sold in Japan went offshore, but as hedge funds have deleveraged their portfolios there has been a glut of inflation products coming back to the mainland, causing breakeven inflation of the JGBI to collapse to negative 50bp from 30bp.
The numbers suggest the market anticipates negative inflation stretching out over 10 years, but this is probably not an accurate assessment. According to Sebastien Goldenberg, global head of inflation products at Citi, reading too much into the market at such a time of dislocation is misleading.
Interest rate swaps form the basis of almost all fixed income hedging products, so stress in this market is quickly exported. In early October the market experienced significant levels of volatility for 10 business days in a row, with bid/offer spreads blowing out by 10 times.
Since the collapse of Lehman, the market has been driven principally by a replacement trade. Corporates that had bought hedges from Lehman have been forced to take their business elsewhere, replacing defunct contracts, said Goldenberg. The failure of other institutions following the Lehman debacle has also amplified the problem, and liquidity has disappeared in every single asset class. Liquidity might return in early 2009, but it is unlikely that interest rates products will be seen as commodities for the foreseeable future.
Headline inflation rates are higher than they have been for 15 years. In the UK, the consumer price index (CPI) hit 4.7% in August, just below the retail price index (RPI) rate of 4.8%, which factors in house prices. In the US, the CPI was 5.4% in August, while in the EU it was 4.2%.
And while inflation rates are universally higher than a year ago, the picture has also grown far murkier regarding expected future inflation. Some reckon that high commodity prices are set to stay and will continue to push the figure upwards, while others point to slowing growth and a possible global recession as evidence that the rate has probably peaked.
Emerging markets have had a different set of experiences – from the West and amongst themselves. The BRIC countries of Brazil, Russia, India and China, regarded by many as the most successful – and certainly the largest – emerging markets, have been blighted by relatively high levels of inflation, but in some instances the problem has been at least partially tamed. In Russia the rate is running at 10.8% in 2008. In China inflation is heading down, and in August hit 4.9%, while in India it is still around 12%.
Yet in emerging markets, just as in those that are more developed, uncertainty prevails as to where inflation is going. How severe a recession Europe and the US might be about to experience, and how such an event will affect Chinese manufacturing or the economies and sectors of other countries, remain billion-dollar questions.
Meanwhile, the evolution of the inflation market has not been uniform throughout the emerging markets. In South Africa and Brazil, for example, the market has developed further than it has in South Korea, though it remains most advanced in developed, G10 economies. Overall, illiquidity and sparsely available data makes the picture in emerging markets very unclear.
In fact, emerging markets are not the only place where the outlook is unclear. The world is currently wrestling with opposing pressures for inflation. On the one hand, slowing growth, rising unemployment and falling profits spell a period of deflation in Europe and the US. On the other hand, the liquidity being pumped into the system by governments and central banks around the world provides simultaneous inflationary pressure.
How these pressures will be reconciled remains to be seen, but it may be that there is a period of one or two years characterised by deflation before the inflationary impact of the liquidity being pumped into the system is felt, according to Chris Willcox, head of global rates products at JPMorgan. Currently the money being fed into the system is being hoarded by the banks and while this is the case it will have little inflationary impact, he says. He predicts inflationary pressures will not be keenly felt again until 2010 or 2011.
Overall inflation uncertainty could bode well for derivatives, leading to a potentially high demand for hedging products around the world. Although the inflation market has been benign, the market has matured. Liability driven investment (LDI) products, for example, increasingly form the cornerstone of pension fund portfolios, driving up demand for rates and inflation hedging instruments.
LDI and inflation hedging is likely to become more popular in the future, not least as pension funds and insurance companies come to terms with some of the big NAV drawdowns that are likely to be widely experienced around the world as a result of the current crisis.
The spectre of headline inflation has driven evolution particularly at the short end of the curve, though there is a market for long-dated inflation hedging. However, the emphasis now is on a return to simplicity. End users are displaying a marked aversion to complex derivatives products – both in inflation and elsewhere, says Willcox. And while vanilla products are likely to become more liquid at the expense of more complex structures – where banks have typically generated their fees – the margins and risk premiums associated with those vanilla structures are also likely to increase.
Part of the pressure on inflation markets is coincidental. Many of the big players in the market have been dogged by problems that have nothing to do with the inflation markets themselves – one example being Lehman.
The current crisis will cause institutions of all types to examine their own processes and risks, and banks will clearly be at the forefront of this. But the whole industry – clients, banks and regulators – must also look at their own role in bringing about the current market problems. There has been an underlying assumption in market initiatives that best execution simply involved obtaining the lowest price – and that the lowest price was necessarily the best price. Recent events suggest the lowest prices in the market may not have been the most accurate reflection of the price of risk, but may have underpriced it, says Willcox.
In the meantime, derivatives of all types face the challenge of escalating mistrust in the financial universe between financial institutions, and the fear of counterparty exposure. The credit crunch has left banks probably more fearful of taking on counterparty exposure than of inflation. “Counterparty selection is all-important now,” said Harry Harrison, head of US dollar fixed income trading and European linear trading at Barclays Capital.
Finding and implementing a solution to this problem is likely to dominate the agenda for inflation derivatives professionals in 2009 and beyond. The two most likely solutions are the creation of a central clearing house for OTC trades, or a move to greater use of exchange-traded inflation derivatives.
Exchange trading is a simple solution, but may not provide the flexibility for the breadth of views that corporates have on inflation. “Corporates have different inflation profiles so standardised contracts are not that useful to everyone,” said Domenico Azzollini, head of interest rate, credit exotic trading and non-linear trading in Europe at Barclays Capital.
A clearing house for OTC derivatives might be a better solution, in that it allows banks to offer highly bespoke products to their clients depending on their specific views, while eliminating the counterparty risk implied by entering into such a contract with one bank.
Willcox believes such a solution may overstate the problem with regard to inflation derivatives, which do not have the same level of complexity and legal uncertainty as credit derivatives – with which this solution is more often associated.
But Heiner Seidel, a spokesperson at Eurex, said it aims to be clearing OTC products of all types – not just credit derivatives but inflation and equity products too – and hopes to be seeing growth in volumes by early 2009.