Inflation hedging back in focus after US election result

To quote the Bank of England¹, inflation swaps are “like the crystal ball of inflation expectations, allowing traders to hedge against inflation risk and giving us a peek into the minds of market participants”. With the recent Trump election victory and prospect of a return to US protectionism, let’s see what the inflation swap markets are telling us about expected US inflation and examine how commonly used bond and swap market inflation hedges have performed over recent months.

US inflation view

For a view on expected US inflation, we turn to the expectation of the annual inflation in one year’s time and the five-year average inflation starting in five years’ time, derived from ICAP US CPI Zero Coupon Swap rates.

It’s evident from the chart below that inflation expectations displayed notable dynamics in the two months surrounding the U.S. elections in November 2024. Until late October, both 1-year and 5-year breakeven inflation rates steadily increased, reflecting market anticipation of potential economic changes related to the elections.

Following the election results in early November, the 1-year breakeven rate experienced a sharp spike, signalling high short-term inflation uncertainty driven by the anticipated policy changes. In contrast, the 5-year breakeven rate remained relatively maintained, suggesting that long-term inflation expectations were more stable.

By late November, the 1-year breakeven rate began to decline from its peak, indicating a decrease in short-term inflation uncertainty as markets adapted to changes after the election.

Inflation swap indices can be more appealing for inflation hedging

Building on our recent analysis contrasting the returns of inflation-linked bonds and swaps², we compare the performance of the iShares TIPS Bond ETF with a fully funded monthly rolling US CPI Breakeven Inflation Swap Index (BISI)³of similar duration (providing exposure to both the swap and the overnight rate). Since the iShares TIPS Bond ETF has a duration of 6.74 years, we selected the 7-year US CPI BISI total return as the appropriate index for comparison.

Note: Parameta Solutions US CPI BISI TR is a prototype provided for informational purposes only. In early October, the chart above indicates that the inflation swap index begins to outperform the TIP ETF. This shift likely reflects a change in market expectations for inflation, as represented by the swap index, potentially anticipating higher future inflation compared to what is priced into inflation-linked bonds. That may be explained by the fact that the inflation-linked bonds are more sensitive to changes in interest rates.

As noted in our previous piece, inflation-linked bond returns are driven as much by changes in interest rates as by the inflation expectations. In contrast to this, swap market instruments are a purer play on changes in inflation expectations, which arguably make them more attractive to hold than bonds for investors wanting to separate their inflation and interest rate hedging strategies.

In general, systematic rolling investment strategy in inflation swaps, such as the Parameta Solutions BISI, provides a comprehensive set of building blocks for market participants to:

• facilitate issuance of tracker investment products offering exposure to changes in inflation expectations, at a particular tenor or combination of tenors.

• allow for implementing systematic inflation strategies, such as 2y-10y inflation steepener or flattener, or even dynamically switching between the two tenors based on market or other economic signals.

• may find use in performance measurement or attribution of portfolio returns into inflation expectations component and real yield element.

• as building blocks for bespoke benchmarks for portfolios relative to investment mandates.

© 2024 ICAP Information Services Limited (“IISL”). This communication is provided by ICAP Information Services Limited or a member of its group (“Parameta”) and all information contained in or attached hereto (the “Information”) is for information purposes only and is confidential. Access to the Information by anyone other than the intended recipient is unauthorised without Parameta’s prior written approval. The Information may not be not used or disclosed for any purpose without Parameta’s prior written approval, including without limitation, storing, copying, distributing, licensing, selling or displaying the Information, using the Information in an application or to create derived data of any kind, co-mingling the Information with any other data or using the data for any unlawful purpose of for any purpose that would cause it to become a benchmark under any law, regulation or guidance.The Information is not, and should not be construed as, a live price, an offer, bid, recommendation or solicitation in relation to any financial instrument or investment or to participate in any particular trading strategy or constituting financial or investment advice or a financial promotion. The Information is not to be relied upon for any purpose whatsoever and is provided “as is” without warranty of any kind, either expressly or by implication, including without limitation as to completeness, timeliness, accuracy, continuity, merchantability or fitness for any particular purpose. All representations and warranties are expressly disclaimed, to the fullest extent possible under applicable law. In no circumstances will Parameta be liable for any indirect or direct loss, or consequential loss or damages including without limitation, loss of business or profits arising from the use of, any inability to use, or any inaccuracy in the Information. Parameta may suspend, withdraw or modify or change the terms of the provision of the Information at any time in its sole discretion, without notice.All rights, including without limitation intellectual property rights, in and to the Information are, and shall remain, the property of IISL or its licensors. Use of, access to or delivery of Parameta’s products and/or services requires a prior written licence from Parameta or its relevant affiliates. The terms of this disclaimer are governed by the laws of England and Wales.