Options Traders Produce Breakout in Inflation Expectations

Summary

Conditions are favorable for widening by U.S. TIPS breakevens given hefty economic data improvements and seasonal tailwinds to start 2018. A breakout in short-term inflation expectations by options traders projects potential for 10 bps of widening and nearly 15 bps of out-performance relative to Germany in the month ahead.

Comment

U.S. 10-year TIPS breakevens (197.5 bps) are widening into year-end on the heels of economic data improvements.

TIPS investors know a favorable seasonal begins in January with U.S. 10-year TIPS breakevens widening a median of 8.7 bps. This seasonal tailwind persists through April before turning deeply negative in June.

The chart below shows the ratio between the 2-year inflation swap cap at 2.5% versus floor at 1.5%. We prefer to use inflation swaps and their options since they are less encumbered by the risk and liquidity premiums impacting TIPS breakevens.

This ratio provides the odds year-over-year headline CPI runs above 2.5% versus below 1.5% over the next two years. A ratio above one indicates options traders pricing in a better chance of CPI being above 2.5% over falling below 1.5%.

The orange shaded areas mark periods when the ratio or odds saw a breakout from its 120-trading day range, implying inflation expectations are set to continue their ascent. The last breakout just occurred on December 21, 2017.

However, bounces in short-term inflation expectations have not been met with the same enthusiasm further out the curve since 2015.

The chart below shows the relationships between 2 and 10-year odds CPI runs above 2.5% versus below 1.5%. Rises in 2-year inflation expectations prior to 2015 saw much larger coinciding rises in 10-year inflation expectations. The relationship between these time windows in 2016 and 2017 is essentially an aberration. Will 2018 be the year long-run inflation expectations revert back to more ‘normal’ conditions?

The next chart shows movement by U.S. 10-year TIPS breakevens during the three months following a breakout by the 2-year inflation swap cap/floor ratio shown above. Breakevens widen nearly 10 bps over the ensuing 20 trading days. Note the two strongest widening moves occurred in early 2011 and 2012 with the help of the January through April widening seasonal.

Lastly, the chart below shows changes in the spread between U.S. and German 5-year breakevens during the three months following a breakout by the 2-year inflation swap cap/floor ratio shown above.

U.S. breakevens outperform Germany by the order of nearly 15 bps over the ensuing 20 trading days.