Investors are worried about deflation. That might sound odd, given that the opposite fear — of a push higher in consumer prices — has grabbed attention and fired up assets such as gold.
But the price of options linked to inflation swaps shows that investors are paying up to protect against extreme scenarios at both ends of the spectrum. The probability of price declines in the US has more than quadrupled to 7.5 per cent since the start of this year, those options show, even while the chance of annual inflation running hotter than 2.5 per cent over the next half decade has almost doubled to 8 per cent, according to analysis by NatWest Markets.
The disparity underlines a growing polarisation among investors on one of the biggest questions facing markets. The simultaneous fears of both inflation and deflation also help to explain the breadth of a rally this summer, which has taken in classic inflation hedges like gold as well as government bonds, which benefit from stagnant or falling prices.
“The market is grappling with the risks of both deflation and high inflation,” said Theo Chapsalis, head of UK rates strategy at NatWest Markets. “I have never seen the investment community so divided.”
In the eurozone and the UK too, although the levels of inflation expected are different, the spread of possible outcomes has increased, Mr Chapsalis said.
When the spread of Covid-19 sent global markets into meltdown in March, investors quickly priced in a deflationary shock in all the world’s big economies as the severity of the hit to demand became clear. Inflation expectations quickly rebounded, driven by the stimulus measures put in place to tackle the crisis, namely government borrowing and central bank purchases on a scale never seen before.
The market for inflation swaps — derivatives that allow traders to bet on where inflation will be in the future — is now pricing in US inflation of 1.68 per cent over the next five years, still below the Fed’s 2 per cent target and a similar level to the start of the year. But that average masks lingering anxieties.
“Investors are trying to work out if this is one of those moments where the fundamentals of markets are completely changed,” said Chris Jeffery, a fixed-income strategist at Legal & General Investment Management. “But they’re doing it in the middle of a unique crisis. There’s this slightly academic debate about the long-term effects of the increase in the money supply. Then there’s the grinding reality of month-on-month inflation figures, and to be honest people have a pretty poor handle on what’s driving that.”
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In the US, consumer prices rose 1 per cent in July, faster than expected, following three months of very sluggish gains.
The relatively hefty premiums to hedge against very high or very low inflation make sense given the plausible arguments for both, according to JPMorgan Asset Management strategist Karen Ward. “On the one hand, central banks are under tremendous political pressure to keep rates low, and governments have lost their fear of debt,” she said. “But once furlough schemes come to an end you can see a scenario where companies say ‘you can come back on 80 per cent of your pay, or we let you go’.”
Many fund managers say they expect prices to remain steady, or even fall, in the short term, before sharper rises kick in as economies recover. But even the longer-term implications of the coronavirus crisis are not clear cut, according to Goldman Sachs Asset Management portfolio manager Hugh Briscoe.
“Some structural disinflationary forces have been fast-tracked by this crisis, like the rise of online retail and automation,” he said.
Kacper Brzezniak, a portfolio manager at Allianz Global Investors, said: “The activity in options markets suggests growing demand among investors for hedges against very high or very low inflation. Investors are right to be concerned, given either of these scenarios has the potential to capsize a broad recovery in assets that has encompassed everything from stocks to precious metals and government bonds.
“When we do client calls it’s always one of the top questions that comes up.”
The recovery in stock markets rests on central bank stimulus, which could be threatened by a sharp rise in inflation. Meanwhile, a slump into lasting deflation would mean investors had overestimated the strength of the economic recovery, according to Mr Brzezniak.
“If you think of something that could cause everything to go down, it’s a big surprise on inflation,” he said.