Where Markets Are Hinting at Hedges of Higher U.S. Inflation

(Bloomberg) -- The inflation outlook in the wake of the pandemic continues to divide strategists. One part of the derivatives market is signaling that some investors see a risk of U.S. price pressures building up after the election.

An options measure known as skew for the $18.5 billion iShares 20+ Year Treasury Bond ETF is pricing in a greater chance of a “violent” climb higher in yields than a drop over the next two months, according to Chris Murphy, derivatives strategist at Susquehanna Financial Group LLP.

One explanation is that investors are hedging against the possibility of heightened concern about inflation if “a clear election winner with a clear mandate to spend more money” emerges, he wrote in a note.

For some, stimulus injections and loose monetary policy will in time stoke prices. Others argue the economic toll of the pandemic and stalled fiscal relief point to deflation as the bigger threat.

So-called 10-year breakeven rates derived from Treasury inflation-protected securities and nominal securities have trended down to 1.6% this month, signaling skepticism about the Federal Reserve’s goal of lifting inflation temporarily above 2%.

Other factors could be influencing the skew, Murphy said. These include current historic low yields leaving little room for further declines, doubts about bonds providing a useful stock hedge and worries over America’s rising debt -- all of which might ultimately mean higher yields.

Implied volatility across asset classes, such as gold, points to positioning for a wide range of inflation outcomes that likely hinge on the election result, according to Michael Purves, chief executive officer of Tallbacken Capital Advisors LP.

“Intuitively, it seems like fiscal stimulus is increasingly likely to be delayed until 2021,” he wrote in a note. “It’s hard to see inflation expectations becoming re-energized until we know where fiscal policy resides -- and we may not know where fiscal policy is really going until the election is clearly resolved.”

Of course, Cornerstone Macro LLC strategists including Roberto Perli and Benson Durham say gold may not be that good of a hedge for inflation at all, asserting that it tends to fall when investors are more averse if inflation takes off. They recommend TIPS as an “obvious direct trade” instead.

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