Will Investors Turn To The OTC Derivatives Markets To Satisfy Demand For Inflation Hedges?

As widely predicted, the BoE hiked rates by 0.25% at the May ’23 Monetary Policy Committee (MPC) meeting and many economists are expecting another hike in June. The reality behind this is that UK Inflation remains stubbornly high and as the MPC minutes stated, “risks around the inflation forecast are skewed significantly to the upside”¹. Inflation swaps data from Parameta Solutions shows that swap markets are still pricing in high levels of inflation for some years to come. The chart below shows the expectation of the annual inflation in one year’s time and the five-year average of inflation in the UK starting in five years’ time, implied from ICAP zero-coupon inflation swaps pricing. We should note that UK Inflation swap and bond markets use RPI rather CPI as a reference point, which makes it hard to compare the market’s expectation directly with the BoE’s CPI based 2% inflation target, nevertheless sentiment is clear.

Source: Parameta Solutions

With the backdrop of UK inflation remaining sticky, we are expecting demand for inflation hedges to remain high. Investors wanting to hedge inflation e.g. Pension funds, are typically buyers of inflation-linked Gilts (or “linkers” as they are commonly called in the markets). Linkers can also be used by investors such as hedge funds, wanting to express views on inflation. We note however that a recent £4.5 billion issuance of a 2045 inflation-linked note put out by the UK DMO was oversubscribed by around ten times². With demand outstripping supply at the recent auction, it’s a reasonable assumption that investors are increasingly looking to get exposure through inflation swap markets. Inflation swaps may be used as building blocks to create synthetic exposure to linkers or to match specific liability profiles. However, some investors are hesitant to go this route as the OTC derivatives markets are famously opaque. Things are, however, changing in this respect as Parameta Solutions, known for being a provider of high-quality OTC derivatives market data and risk solutions, is looking to provide investors with more transparency through index and benchmark solutions in the OTC derivatives markets, ICAP Information Services Limited is authorised as a benchmark administrator by the FCA in the UK and recognised by ESMA in the EU. Of course Inflation isn’t just a UK story. Euro area inflation may be stabilizing, but Euro Inflation swap data still provides a unique window on swaps market expectations. The chart below³ shows that while expectations of annual inflation in a year’s time are falling, the expectation of average inflation remains relatively high in the five to ten year horizon.

Source: Parameta Solutions

Footnote: 1.    Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on 10 May 2023 (bankofengland.co.uk) 2.    UK draws record 46.4 billion pounds of demand for new inflation-linked bond | Reuters 3.    Forward breakeven rates implied from ICAP zero-coupon inflation swaps pricing

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