Opportunities in derivatives exchanges in an inflationary environment

Author Name: 
Diego Perfumo, Analyst, ErDesk
Diego Perfumo.JPG

There is potential soaring demand for interest rate contracts on the Chicago Mercantile Exchange (CME), once the Fed is forced to abandon its current zero rate policy

Many central banks around the globe had to take active and aggressive measures to protect their local financial markets and economy during the recent financial turmoil. Thus, interest rates were reduced and quantitative easing of monetary policy brought liquidity back to the market. Fiscal spending was also augmented to stimulate demand, adding more funds available to the market.

This abrupt expansion in the monetary base and government spending might ignite fears of inflation that could bring uncertainty and volatility to the market.

Exchanges that provide interest rate derivatives contracts will thrive in the aforementioned inflationary environment as market participants will need to hedge exposures.

This was the case of the Tokyo Futures Exchange (TFX) when expectations of inflation forced the Bank of Japan (BoJ) to abandon its zero rate policy that prevailed between 1995 and 2006.

Prior to Japan’s zero-rate policy, TFX experienced a 50% decline in Euroyen futures contracts as the market anticipated the BoJ’s policy making hedging redundant. It fell a further 66% once the zero-rate policy came into effect in February 1999.

Low realised inflation expectations coupled with a persistent zero rate policy rendered interest rate hedging unnecessary.

However, as soon as the BoJ abandoned the zero-rate policy, volume in Euroyen contracts quickly reached its previous peak levels. Moreover, volumes in Euroyen contracts started to increase as soon as expectations of inflation started to rise and a change in interest rate policy was apparent.

 

Conversely, demand for interest rate Eurodollar contracts on the CME halved before the Fed began its zero-rate policy on December 16th 2008, and could fall another 65% based on TFX’s case, if the US deflationary environment persists for several years.

 

The US case, however, would appear tobe somehow different from the Japanese one. The US has a much higher deficit than Japan did in those days, and decreases in current foreign funding are widening the fiscal gap. Thus, the US may see no option but to inflate its way out of recession, rendering the zero-rate policy unviable in the long term. Inflation will force the Fed at some point in time to abandon its zero rate policy and raise rates.

 

US money supply is currently growing at its fastest pace ever – in the last four months alone, the Fed doubled the monetary base (M0)

 

The Fed’s recent initiative to repurchase treasury securities and finance the stimulus package sent printing presses into overtime, fuelling inflation fears.This will ultimately force the Fed to abandon its zero-rate policy and raisethe cost of borrowing.

 

Recent events explain why monetary base has increased so drastically

 

Higher rates will boost demand for hedging, driving volumes in interest rate derivatives, just as was the case when Japan abandoned its zero-rate policy.

Graph 7: Expectation of inflation implied by the Euroyen price and volume

in ¥ million

 

Demand for inflation hedging will come from multiple participants around the globe that got used to a low US inflationary environment – e.g., US pension funds, where the future payouts to retirees are indexed to inflation; US endowment funds that pay for goods and services (salaries, premises, etc) that escalate with inflation; life insurance companies; consumers of commodities as the dollar weakens; and corporations around the globe with cross-border trading (as the dollar is the main trade currency of the world.) 

This widespread global demand to hedge US inflation will eventually bring the volume levels of CME interest rate derivatives to levels higher than those seen before the crisis, and promising well for other exchange-traded instruments elsewhere, too.

About Bernardo Mariano

Bernardo is an analyst at ERDesk  covering exchanges and trading technology firms in the cash, derivatives, energy, and FX markets in the US, Europe, Asia, and Latin America. He has also has an extensive experience structuring private deals for the acquisition of mutual exchanges. Prior to joining ERDesk Bernardo worked as a Director for Instinet and later, CEO of Reuters' Bondex. Bernardo has regularly been quoted in the media, including The Wall Street Journal, Financial Times, Traders Magazine, Brazil Economic, Traders Magazine and others. He holds an MS in Economics from The University of Illinois and a MIA in Finance from Columbia University.