Options Suggest Traders Overconfident About Inflation Forecasts

(Bloomberg) -- The market is far too confident in its ability to forecast inflation, according to Bank of America Merrill Lynch.

The cost of betting that U.S. inflation will exceed 2 percent or fall below 1.5 percent in about a year is close to record lows, observes strategist Mark Capleton.

"The pricing of one-year U.S. inflation caps and floors suggests a market that is overconfident about its forecasting ability," he writes in a note to clients on Wednesday.

This boosts the attractiveness of an inflation strangle trade -- in which an investor purchases a cap and floor option of the same maturity, and stands to gain based on whether price changes come in above the cap or below the floor. If the rate of inflation is between the cap and the floor, the options expire worthless.

Capleton reckons the subdued cost of these options is yet another manifestation of the low-volatility environment that’s pervaded virtually every asset class. But in this case, complacency isn’t warranted based on the behavior of inflation on a more granular level, he argues.

"One potential justification for greater value being placed on inflation uncertainty in the U.S., we would argue, is the high level of current dispersion in the inflation rates of the components that make up the CPI," the strategist writes. "We wonder whether arguments that might be made for lower implied volatility in securities are necessarily applicable to a future CPI print anyway."

More than 80 percent of the components of the Consumer Price Index basket are seeing annual inflation above 3 percent or less than 1 percent, a share that’s elevated based on history.

Based on the current cost of the options, putting on the inflation strangle outlined by BofA would be a profitable trade if headline CPI inflation were to exceed 2.4 percent or fall shy of 1.1 percent in February 2018.

Backtesting this strategy through October 2010 -- under scenarios in which caps and floors 25 basis points on either side of the swap rate existed and could be purchased for 40 cents -- the payoff would have averaged 17 cents after deducting the cost of premiums, Capleton said.

To contact the reporter on this story: Luke Kawa in New York at lkawa@bloomberg.net.

To contact the editors responsible for this story: Jeremy Herron at jherron8@bloomberg.net, Dave Liedtka, Randall Jensen