FxWirePro: Decisive hedge against inflation risk in 2018

USD strength through 1Q seems to be faded as the greenback has been unsuccessful to respond to the tax reforms, disinflation uncertainty is weighing once more, and the Fed is not indicating the pace of hikes for 2018 despite building in assumptions of fiscal stimulus.

The sharp post-CPI SEK rally is a template for how currencies might react if assumptions of quiescent inflation are upended. Event trading inflation releases via pre- vs. post- calendar spreads have been historically profitable and could prove to be a viable source of vol alpha in 2018.

While the Goldilocks atmosphere in 2017 has pre-eminent valuations for both fixed income and equity avenues. With inflation not materializing, central banks have been dovish in hiking cycle, and term premiums have been passive, serving bond valuations overall. Equity investors often cite low bond yields to justify the attractiveness of equities in terms of equity-risk premium.

As a result, valuations have reached significant highs. This, in turn, leads bond investors to cite equity drawdown risk as a reason to allocate to bonds and hence keep bond yields low. However, we believe that a sustained upward surprise in inflation will also bring about a change in the dollar trend, so these risks are non-linear and convex.

On the one hand, bonds are likely to see their value inflated away, bringing losses for investors in real terms, thereby causing outflows. Higher interest rates would add to the pain by bringing marked-to-market losses to bond portfolios in nominal terms.

On the other hand, a move higher in inflation and interest rates (back to end-cycle norms) can elevate corporate expenses and reduce profit margins by 7-8pp, even without any slowdown in growth being priced.

Moreover, a sustained rise in the dollar is likely to hurt top-line growth, as a significant portion of revenues is generated outside the geographical boundaries of the US. The IT sector, which generates 60% of sales from international markets, has contributed c.40% of the upside in the S&P 500 so far this year.

As such, it is easy to see how higher inflation, higher interest rates and a higher dollar present non-linear risks to equities – especially in the US. Asset managers could be especially vulnerable to an equity market sell-off caused by inflation.

Hedge against an inflation-led sell-off (equities down, rates up)

Buy S&P 500 Sep18 95% put conditional to US 10y CMS>ATMF+10bp for 1.08% - 65% discount to vanilla cost of 3.06% (refs. 2639 and at 2.47). Courtesy: SG