CONTENTS

 

 

Introduction and summary

By David Wigan and Duncan Wigan, Editors

  • Inflationary and deflationary pressures
  • Products and strategies
  • Key topics and findings

 

Chapter 01        Is inflation dead, or about to awake?

By Michael Saunders, Managing Director, Head of European Economics, Citigroup

  • Inflation forecasts
  • The effects of policy stimulus
  • Managing the policy stimulus exit strategy
  • Will inflation targeting continue?

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Chapter 02    Commodities and inflation: a framework for asset allocation

By Francisco Blanch, Head of Global Commodities Research, and Gustavo Soares, Commodity Strategist, Banc of America Securities-Merrill Lynch

  • Overview
  • What is inflation? Where does it come from?
    • Short-term drivers of inflation
    • Long-run trends affecting inflation
    • Inflation patterns in advanced and developing economies
    • Inflation, interest rates, and currency fluctuations
  • A framework to think about inflation in a portfolio context
    • What is inflation risk in an investment context?
    • What are some of the inflation-linked instruments available?
    • Protecting a portfolio against inflation risk
    • From portfolio construction to asset liability management
  • Commodities as an inflation hedge
    • Inflation and commodity prices
    • Monetary policy, the value of money and commodities
    • Long-run trends in commodity prices and inflation
    • Gold as the ultimate way to store value
  • The financial crisis of 2008–09 and the outlook for inflation
    • Should investors worry about inflation or deflation in 2009?
    • Will inflation be a problem for OECD economies in the short run?
    • Can inflation put the economic recovery at risk in emerging markets?
    • Capacity utilisation has collapsed, but not in commodities
    • The commodity super-cycle is not over, just resting

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Chapter 03   US inflation markets: Treasury Inflation-Protected Securities (TIPS)

By George Goncalves, Chief Treasury & TIPS Strategist, Morgan Stanley

  • Macro inflation view
  • TIPS as an inflation asset class
    • TIPS inflation indexation function
    • Market size
    • Seasonals
  • US inflation market supply
    • Inflation-indexation demand
  • TIPS breakevens (BEI) – what are they?
    • Strategy 1 – TIPS breakevens trade
    • Alternative to strategy 1 – ETF-based BEI view
    • Strategy 2 – TIPS on asset swaps
    • Strategy 3 – 5y5y forward TIPS breakevens
  • Tax treatment
  • Conclusion

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Chapter 04    The UK inflation market

By Kevin Mountain, Inflation Linked Gilt Trading, and Adam Baker, Vice President, Inflation Structuring, JP Morgan

  • Historical background
  • Comparing the Retail Price Index and Consumer Price Index
  • Three-month and 8-month lags
  • Inflation issuance
  • Recent government issuance
  • Secondary market in UK index-linked gilts
  • Accreting asset swaps and relative value comparisons
  • Inflation legislation relating to occupational pensions
  • The growth of LDI in the UK market
  • LPI structures

 

Chapter 05    Eurozone inflation

By Stephane Salas, Global Head of Inflation Derivatives, and Sandrine Ungari, Strategist, SociОtО GОnОrale

  • The European sovereign market in perspective
    • Pre-1998: Birth of the inflation cash market
    • 1998–2002: Infancy of the cash market and birth of the derivatives market
    • 2003: Big Bang for eurozone inflation market
    • Late 2003–2004: Asset swaps on eurozone ILBs
    • 2005: Inflation forecasting
    • 2006: Spread France–Europe and hybrid structures
    • 2007: Inflation range accruals and LDI on the eurozone  market
    • 2008: Ideas of further innovations meet with dislocations
    • Long-term Greek inflation linkers vs long-term Italian linkers
    • Term structure of zero-coupon swaps: steep front end and inverted long end
    • French breakevens well above European breakevens in swap and bond space
    • Swap versus bond breakevens on asset swap unwinding
    • General increase in market volatility
  • Eurozone characteristics in a nutshell
    • Inflation convergence in the eurozone?
    • European and domestic inflation: France/Europe spread
    • Inflation options market and Inflation linkers: what link?
  • Conclusion

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Chapter 06    Emerging markets sovereigns

By Catherine Mactaggart, Emerging Markets Product Specialist, and Eduardo Levy-Yeyati, Head of EM Strategy, Barclays Capital

  • Why inflation linkers?
    • Inflation linkers in Latin America
    • Inflation linkers in EMEA
  • External shocks and breakevens
  • Regional linker markets
    • Brazil
    • Argentina
    • Mexico
    • Chile
    • Uruguay
    • Peru
    • Emerging Europe, Middle East & Africa
    • Emerging Asia Pacific
  • New entrants
    • The contrasting case of South Africa and Poland
    • International inflation investors matter
  • Barclays Capital Emerging Market Global Inflation-linked Index (EM GILB)
  • What the future holds

 

Chapter 07        Inflation risk management and corporates

By Ed Piombini, Director, Risk Solutions Group, Barclays Capital

  • Debt liability hedging
    • De-risking of financial metrics
    • Cash flow profiling
    • Investor diversification
    • Diversification of interest costs
  • How have debt liabilities been linked to RPI?
  • What inflation derivatives could a corporate opt to use in hedging debt liabilities?
    • Pre-hedging using derivative instruments
    • Transforming fixed or floating debt into inflation-linked debt
    • Revenue hedging
  • Recent and future developments
    • Potential for issuance
    • Hedge accounting for RPI swaps?
    • Volatility of inflation
    • Expansion of inflation risk management internationally?
  • Conclusion

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Chapter 08    Inflation-indexed swaps and other derivatives

By Dariush Mirfendereski, Managing Director, Head of Inflation Linked Trading, UBS Investment Bank

  • Introduction
    • Why inflation derivatives?
    • The fourth yield curve
    • Additional spreads defined
    • Standard market instruments
  • The main global inflation derivative markets
    • The US CPI derivatives market
    • The eurozone inflation derivatives markets
    • The UK RPI derivatives market
  • Supply and demand for inflation derivatives
    • What do we mean by ‘natural’ inflation supply?
    • Hedging inflation swaps using inflation-indexed bonds and IRSs
    • Inflation-indexed bond asset swaps – the supply of last resort
  • Formal definitions and notation for relative value analysis
  • Historical data
    • The US market
    • The UK market
    • Eurozone markets
  • Unified theory for inflation bond and swap relative value
  • Detailed US CPI market data analysis
    • Libor-GC historical spreads
    • Three distinct time periods
    • Implications for the inflation-indexed bond ASW market
    • 5y5y inflation forwards
    • The market post-Lehman
  • Market quirks: seasonality and fixing risks
    • Seasonality
    • Fixing risks
  • Future of the market

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Chapter 09    Structured notes

By Adam Baker, Vice President, Inflation Structuring, JP Morgan

  • Introduction
  • Historical overview – inflation buyers
  • Note issuers
  • What limited market expansion?
  • Inflation-linked structural innovation
  • Further developments in the inflation market
  • Current market conditions
  • Credit implications
  • The domestic inflation market
  • Secondary market
    • Modelling volatility
  • Hybrid products
    • Equities
    • Commodities
    • Oil
    • Rates
  • The future
  • Conclusion

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Chapter 10    Inflation Indices and ETFs

By Daragh McDevitt, Global Head of Inflation Structuring, Deutsche Bank

  • The need for simplicity
  • Government inflation bond indices
  • Inflation breakeven indices
  • Proxy indices
  • Algorithmic indices: dbInspire
  • Access to indices using ETFs – a brief history
  • The advantages of ETFs
  • ETF structures and applications
    • Direct investment
    • Swap replication
  • Inflation ETFs
  • Access to inflation using ETFs in the future
  • Conclusion

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Chapter 11    Inflation trading strategies

By Guillaume Tresca, Inflation Linker Strategist, Global Interest Rates Strategy, Calyon-CrОdit Agricole CIB

  • Introduction
  • Linkers and deflation: what’s the strategy?
    • Strategies for shortest and youngest linkers
    • Recommendation summary – short deflation period
  • Strategies for a long severe deflation
    • Recommendation summary for long deflation period
  • Chasing inflation breakevens
    • Breakeven trade: a bet on future inflation
  • A technical approach: how low can breakevens go?
  • Trading the breakeven curve
  • Real asset swaps
  • Eurozone–France arbitrage

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List of tables and figures

 

Table 2.1: US agricultural prices and food inflation
Table 4.1: Linker issuance as a proportion of total issuance, 2004–09
Table 6.1: UDI Bonos – bond structure and amount outstanding as at 12 February, 2009
Table 6.2:  BCU Bonos – bond structure and amount outstanding
Table 6.3: ‘New’ entrants to the EM sovereign linker market
Table 7.1: Interest cover ratios and declining inflation rates scenarios
Table 7.2: Debt:RAV cover ratios and declining inflation scenarios
Table 7.3: Illustrative example of revenue swap
Table 8.1: Outstanding notionals for CPI-linked notes by maturity date
Table 8.2: Notation for real/nominal and government/Libor pairings defining rates
Table 10.1: Inflation ETFs in Europe


Figure 1.1: Average CPI inflation for the industrial countries, 1970–Jan 2009
Figure 1.2: Central bank balance sheets as % of annual GDP, 1990-2009 for US, euro area, Japan and UK
Figure 1.3: Annual change in international bank assets, 1970-2008 (US$bn)
Figure 1.4:  Bank of England estimates of approximate frequency of hitting zero interest rate bound with different levels of inflation target
Figure 2.1: Correlation of commodities and realised inflation (%)
Figure 2.2: US consumer prices historic yearly inflation rates (%)
Figure 2.3: OECD economies’ long-term trends on inflation rates, 1959–2007 (%)
Figure 2.4: Commodity price trends, 1970–2008
Figure 2.5: Percentage of years with annual inflation above 20% or 40%, 1800–2006, various economies
Figure 2.6: Inflation and volatility of inflation in OECD economies (%)
Figure 2.7: Correlation of annual average debt and inflation since 1998, Brazil, Mexico, Turkey (%)
Figure 2.8: Debt and inflation rates, 2008 (%)
Figure 2.9: Financing costs for sovereigns, March 2009
Figure 2.10: Credit outstanding and YoY inflation rates, March 2009, various economies (%)
Figure 2.11: Comparison of volatility of inflation rates and financial assets in OECD economies (%)
Figure 2.12: Correlation of commodities compared to other asset classes with year-on-year inflation rates (%)
Figure 2.13: Performance of equity sectors in high inflation environments, Jan 2005–Feb 2009 (%)

Figure 2.14: Long-term correlation of various commodities with year-on-year inflation rates, 1990–2008 (%)
Figure 2.15: Assets with low correlation with each other allow investors to drastically reduce the volatility of their portfolio
Figure 2.16: IL bonds tracking error to inflation on a mark-to-market basis (%)
Figure 2.17: Merrill Lynch portfolio performance compared to TIPS and inflation, 1997–2007
Figure 2.18: Correlation of Merrill Lynch portfolio with monthly US CPI inflation rates (%)
Figure 2.19: Bias of pension fund investment in equities
Figure 2.20: UK pension fund assets and liabilities, Mar 2003–Mar 2008(£bn)
Figure 2.21: Components of US CPI inflation basket
Figure 2.22: Components of UK RPI inflation basket
Figure 2.23: Impact of commodity prices on cumulative year-on year inflation rates (%)
Figure 2.24: Correlation between commodity prices and inflation in OECD and EM countries, Jan 1989–Dec 2008 (%)
Figure 2.25: Expansion of global money supply, 2006–08
Figure 2.26: Comparison of oil price rises with increased money supply
Figure 2.27: Cumulative impact of a 100bps decrease in US real interest rates on year-on-year growth in the S&P GSCI spot index
Figure 2.28: Impact of energy price volatility on inflation, 1989–2007
Figure 2.29: Effect of low US real rates on commodity prices (%)
Figure 2.30: Effect of low Chinese real rates on commodity prices (%)
Figure 2.31: Historic relationship of primary energy commodities to global GDP (%)
Figure 2.32: Commodities real price appreciation, 1927–2007
Figure 2.33: EM economies’ share of world GDP, 1980–2012 (e) (%)
Figure 2.34: Commodities prices compared with GDP growth, 1983–2007
Figure 2.35: Above-ground gold stocks and their deployment, 2007 (tonnes)
Figure 2.36: Average annual gold prices, 1971–2006 (US$/oz)
Figure 2.37: Average gold outperformance under hostile market conditions (%)
Figure 2.38: Comparative portfolio improvement in hostile market conditions through inclusion of gold (%)
Figure 2.39: GDP growth rates, 2003-4Q08 (%)
Figure 2.40: Industrial production rates, 1980–4Q08 (%)
Figure 2.41: Central bank monetary policy interest rates, 2005–09
Figure 2.42: Fiscal stimulus packages as % of GDP, various economies
Figure 2.43: US, UK and euro inflation rates, Feb 2008–Feb 2009 (%)
Figure 2.44: EM inflation rates, 2004–08
Figure 2.45: Unemployment rates in US, UK, Ireland, Spain, Jan 2003–Jan 2009 (%)
Figure 2.46: OECD PMI survey results, 2002–09
Figure 2.47: US residential and commercial real estate capacity, 1972–2008 (%)
Figure 2.48: Durable goods inventories, OECD economies, 1992–2008
Figure 2.49: EM debt, Feb 2008–Feb 2009
Figure 2.50: Money supply and credit expansion in China, 1999–2009 (%)
Figure 2.51: US capacity utilisation rates, various industries, 2002–07
Figure 2.52: US commodity utilisation rates, 2008

Figure 3.1: Growth rate of money supply vs. declining money multiplier and velocity
Figure 3.2:  Market conditions for investment in TIPS
Figure 3.3: US Consumer Price Index composition
Figure 3.4: 10-year TIPS coupon structure (less principal)
Figure 3.5: TIPS market size outstanding, 1997–2008 (US$bn)
Figure 3.6: TIPS BEI seasonals vs. drivers of inflation on a monthly basis – TIPS breakeven performance track actuals
Figure 3.7: TIPS takedown by top four auction participants, 2000–2008 (%)
Figure 3.8: 10-year real yields vs. Fisher equation implied 10-year real yields
Figure 3.9: Strategy 1 – TIPS breakevens (bond market vs. ETF-based)
Figure 3.10: Strategy 2 – 10-year asset swap spreads
Figure 3.11: Strategy 3 – 5y5y forward TIPS breakevens used to be stable view of future inflation

Figure 4.1: Bank of England base rate change vs. RPI– CPI spread, 1989–2007
Figure 4.2: Index-linked gilts outstandings, 1981–2007 (£bn)
Figure 4.3: Inflation-linked gilt real yield, Sep 2005–Mar 2009
Figure 4.4: UK swap market volume, Jan 2005–Jul 08
Figure 4.5: Illustration of LPI using stylised inflation path

Figure 5.1: Outstanding inflation-linked government bonds, 1982–2006 (US$bn)
Figure 5.2: Eurozone secondary market volumes, Jan 2002–Jan 2007 (џm/month)
Figure 5.3: Inflation market timeline: from market infancy to structured product age
Figure 5.4: Breakeven for the GGBei 2025 and the BTP 2035, Oct 2006–Oct 08
Figure 5.5: Spread between the breakevens of the GGBei 2025 and the BTP 2035, Oct 2006–Oct 08
Figure 5.6: ZC swap breakeven term structure, Mar 2007 and Mar 2009
Figure 5.7: BEIR spread between the 10y ZC inflation swap and 30y ZC inflation, Mar 2005–Mar 08
Figure 5.8: BEIR for OATi Jul 2013 and OATei Jul 2012
Figure 5.9: BEIR spread between OATi Jul 2013 and OATei Jul 2012
Figure 5.10: BEIR for OATei July 2020 and 10y ZC inflation swap
Figure 5.11: BEIR spread: 10y ZC inflation swap and OATei July 2020
Figure 5.12: Increase in inflation and nominal volatilities, Jan 2008-Jan 09
Figure 5.13: Euro HICP annual inflation (revised series), 1997–2009 (%)
Figure 5.14: Spread between highest and lowest inflation for 9 main countries in HICPXT, 1997–2009 (%)
Figure 5.15: French national index versus French harmonised index, Jan 1997–Jan 2007 (%)
Figure 5.16: UK RPI versus UK harmonised index, Jan 1997–Jan 2007 (%)
Figure 5.17: Inflation implied volatility surface for YoY options
Figure 5.18: Inflation implied YoY volatility for 1y, 3y and 5y expiries

Figure 6.1: Emerging market CPI inflation, Jan 2004–Jan 09 (YoY, %)
Figure 6.2: Sensitivity of EM inflation to external shocks
Figure 6.3:  BarCap Argentina Inflation-Linked Index, Dec 2003–Dec 08 (in ARP)
Figure 6.4: Mexican core and non-core CPI (%, YoY)
Figure 6.5: Udibonos total return, 12 Dec, 2004–08 (%)
Figure 6.6: Chilean central bank debt structure, 2002, 2007, 2008 (% of GDP)
Figure 6.7: New entrants – Korea
Figure 6.8: New entrants – Turkey
Figure 6.9:  BarCap Constrained EM Government Inflation-Linked Index, Dec 2003–Dec 08 (local currency)

Figure 7.1: Combined revenue swap and interest rate swap

Figure 8.1: Schematic representation of real and nominal government bond and swap rates and their related spreads
Figure 8.2: Hedging a swapped new inflation-indexed issue without inflation-indexed swaps
Figure 8.3: Inflation-indexed bond par/par asset swap cash flows
Figure 8.4: Inflation-indexed bond proceeds asset swap cash flows
Figure 8.5: Schematic representation of continuously compounded zero rates and their related spreads
Figure 8.6: US market zero nominal spreads vs. inflation rich/cheap for 5-, 10-, and 20-year maturities
Figure 8.7: UK market zero nominal spreads vs. inflation rich/cheap for 5-, 10-, 15-, 20-, 25-, and 30-year maturities
Figure 8.8: Eurozone market zero nominal spreads vs. inflation rich/cheap for 5-, 10-, 15-, 20-, 25-, and 30-year maturities
Figure 8.9: Eurozone market zero nominal spreads vs. inflation rich/cheap for 5-, 10-, 15-, 20-, 25-, and 30-year maturities
Figure 8.10: 3-month Libor-GC USD spreads, Jan 2006 - Jan 2009
Figure 8.11: 5-year zero nominal spreads vs. rich/cheap
Figure 8.12: 10-year zero nominal spreads vs. rich/cheap
Figure 8.13: Treasury- and swap-implied 5y5y inflation forwards
Figure 8.14: 5-year and 10-year zero nominal spread vs. time
Figure 8.15: 5-year and 10-year rich/cheap vs. time
Figure 8.16: rich/cheap in 5- and 10-year maturities, Jan 2006 - Jan 2009
Figure 8.17: 5-year and 10-year zero nominal spread vs. time
Figure 8.18: Nominal spread vs. rich/cheap in the 5-year maturity, Jan 2006 - Jan 2009
Figure 8.19: Nominal spread vs. rich/cheap in the 10-year maturity, Jan 2006 - Jan 2009


Figure 9.1: Comparing returns in a real and nominal framework with differing inflation rates
Figure 9.2:  Success of inflation targeting, European Central Bank and Bank of England
Figure 9.3: The changing perception of inflation as a return-generating asset class
Figure 9.4:  The international inflation market
Figure 9.5: Evolution of German CPI YoY against Euro HICP YoY
Figure 9.6: Breakdown of Euro HICP against German CPI YoY spread by sub-index
Figure 9.7: Correlation between Eurostoxx 50 YoY return and Euro HICP YoY
Figure 9.8: Instability of the real return of gold
Figure 9.9: Correlation between 3m Euribor and Euro HICP YoY


Figure 10.1: Country allocation: db Liquid Inflation (G10)
Figure 10.2: Country allocation: db Liquid Inflation (Global)
Figure 10.3: db Liquid Inflation Index suite performance, Mar 2007–Mar 09
Figure 10.4: DB breakeven indices 10-year (rebased) performance, Mar 2007–Mar 09


Figure 11.1: US inflation swap curve price deflation
Figure 11.2: Shortest linkers have been hit hard (real yield)
Figure 11.3: 10Y US breakeven and model
Figure 11.4: 10Y eurozone breakeven and model
Figure 11.5: US breakeven levels needed for index ratio of 1.0 at maturity
Figure 11.6: Eurozone breakeven levels needed for index ratio of 1.0 at maturity
Figure 11.7: Eurozone inflation seasonality
Figure 11.8: Eurozone breakeven seasonality and lagged inflation seasonality
Figure 11.9: Real asset swap cheapening vs. nominal equivalent (pickup)
Figure 11.10: US inflation note monthly issuance
Figure 11.11: Eurozone and France 5Y5Y inflation swap rates
Figure 11.12: Eurozone and France inflation swap curves

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