Three derivative signals every multi-asset investor should watch in 2023
We share three signals from derivatives markets that could help investors uncover market opportunities in 2023.
Mark Greenwood, Deputy CIO & Head of Investment Risk
Signal one - Inflation swaps: Understanding central bank reaction functions
Most investors are familiar with inflation-linked bonds which make up almost 15% of all G7 government bonds. These “linkers” allow us to derive breakeven inflation as a crude measure of inflation expectations, using the difference between nominal and real yields. However, we believe deriving future expectations from inflation-linked derivatives is a more reliable and precise approach. Our weapon of choice here is the inflation swaps market. We decompose zero coupon inflation swaps into implied future inflation rates for each major market.
These forward inflation rates of UK RPI inflation shown in chart 1 have been as predictive of future inflation as the Bank of England’s own model used in its famous inflation fanchart. The Old Lady’s projections are only available quarterly though, while the inflation swap market allows us to monitor future inflation expectations in real time.
Source: Atlantic House, Bloomberg, 30 September 2022
The chart shows this market believes UK inflation has peaked and will decline to around 6.5% by the end of 2023 for RPI (or around 5.5% for CPI). Since every future monthly inflation date can be traded in the RPI swaps market, we can say with some confidence that UK inflation peaked at 11.1% for CPI and 14.2% for RPI inflation in October. If our mild winter continues, the swaps market says inflation will gradually decline in 2023 to settle slightly above target.
The US CPI curve is now essentially flat at around 2.75%, showing that the market has given the Federal Reserve the benefit of the doubt – for now – but any rise in medium-term market expectations will force the central bank back to a hawkish stance. The Bank of England still has some work to do.
Signal two - Swaptions: When will the Fed pivot?
While a data-led Fed will be watching the inflation-swaps market for signs of hardening inflation expectations, what does the interest rate derivatives market tell us?
In the chart below, we examine the progression of 3-month into 1-year swaption implied volatilities for at-the-money and 1% out-of-the-money strikes. When the latest core US inflation figure was increasing in September and October, the higher volatility for the high strike swaptions implied the risks were skewed towards higher for longer policy rates. In November the October core CPI fell to 6.3% from a peak of 6.6% and the markets judged the risks to be more evenly balanced. Right now, the swaptions market sees the risks tilting towards lower policy rates in 2023. Monitoring these key implied volatilities allows us to judge the risks to the Fed’s anticipated dovish pivot in late 2023.
There’s another good reason to monitor the skew (the difference between high and low strike implied volatilities) – it is generally a good predictor of the direction of travel for the underlying assets. Derivatives activity tends to be more active and informed than investors limited to the underlying markets, so it pays to follow the skew. Indeed, this strategy has proven a reliable source of alpha for hedge funds in the past. Extend cash investments out by a year for as long as low strike (“receiver”) swaptions volatility is higher than high strike (“payer”) volatility.
Source: Atlantic House, Bloomberg, 30 September 2022
Signal three - Volatility derivatives: When to pounce on inevitable equity market wobbles in 2023
The buy the dip mentality that served meme and crypto investors so well at the start of this decade has been well and truly shattered. There will be dips and buying opportunities will be harder to discern in 2023.
The VIX is a well-known indicator of risk appetite, but we believe the VIX futures strip is more insightful. VIX futures are active for the next 6 monthly expiries and the shape of this curve is often more meaningful than the outright level. Using VIX futures to take a long volatility position to hedge risk assets is expensive when the term structure is in its natural upward sloping position, as it is presently:
There will inevitably be wobbles in markets this year as central banks attempt to softly land economies in turbulent conditions. In fact, an inverted VIX curve (when 1-month VIX futures are trading higher than 3-month VIX futures) has often been a precursor to imminent market stress. Investors could take this as their cue to either lighten their equity exposure or add long volatility protection. Only adding protection on VIX inversion limits reduces the negative carry from rolling down an upward sloping term structure and can produce positively convex outcomes in uncertain times. This convexity results from long volatility protection outperforming the market on a steep decline or the market exposure outperforming the long volatility protection on a significant rebound. Indeed, we utilise this positive convexity systematically in several of our Atlantic House funds.
Source: Chicago Board Options Exchange, Bloomberg, 30 September 2022
Mark Greenwood, Deputy CIO & Head of Investment Risk, Atlantic House Group