USD Inflation – the barbed wire hedge
Ross Beaney posted a great blog on the Texas hedge which has attracted much interest. Ross provided the definitions for a Texas hedge as:
Oxford Reference Dictionary - The opposite of a hedge, which is intended to reduce risk. In a Texas hedge risk is increased, e.g., by buying more than one financial instrument of the same kind
Collins Online Dictionary - the opposite of a normal hedging operation, in which risk is increased by buying more than one financial instrument of the same kind.
He applied this to the Term RFR and compounded RFR markets to demonstrate the challenges of hedging one with the other.
Today I will look at the barbed wire hedge and I thank Andrew Baume for reminding me of this hedge variant in our LinkedIn post! So, what is a barbed wire hedge?
A definition for this unusual hedge is not available using the usual search methods on the internet because the term probably fell from common use in markets before the internet was ‘a thing’. My last recollection (before Andrew reminded me) was possibly in the early 1990’s and it was described as:
‘A barbed wire hedge is one where it does not matter which leg you lift to extract yourself from the risk and/or hedge, you are in trouble!’
The picture tells it all……….
In this blog, I look at the USD inflation markets and how the barbed wire hedge is an apt description for the challenges faced by many hedgers and the dealers who provide the prices.
Inflation history
The following chart is for the annual inflation printed in USD over the past 10 years. I use the annual data because it removes the considerable seasonal variations in US CPI and focusses on the actual trend.
There has been little or no trend until 2020/21. Everyone has noticed the increase in inflation in 2021 and 2022 which is clear in the chart above. We have had relatively low inflation for many years which has been broadly in at the Fed target of 2%. This can be seen in the next chart showing annual inflation outcomes since 1960 where inflation since 1995 has moved in a band between 0% and 4% oscillating around 2%.
But now we are close to 5% and trending up. Interest rates aside, what should we do to directly hedge our inflation risk? Will inflation peak this year as many expect? Or will inflation become more entrenched as we see happened from the mid-1970s to the mid-1980s?
I will not cover the possible causes for higher inflation in this blog but rather look at the challenges for hedging and what this can mean for hedgers and dealers.
Looking forward and inflation expectations
The following chart shows the 10-year forward USD inflation expectations over the past 10 years.
The markets clearly expected 10-year inflation averages to be around the 2% target until the COVID19 drop in early 2020 to a low around 0.5%. This quickly reversed as markets expected the US market to recover more quickly and priced in higher inflation.
The next chart shows the current, implied forward USD inflation rates (annually) for the next 10 years. The 10-year inflation swap is around 2.7% which incorporates the current expectation at 5.38% but the forward rates fall rapidly to 2% - 3% in subsequent years.
Markets are very clearly pricing a very transitory period of inflation followed by more ‘normal’ inflation rates around 2% after 2023/24.
The hedge challenge – the classic barbed wire hedge
With current inflation rates higher than in the past 20 plus years and seemingly trending up, there is an immediate decision for many firms to consider hedging. Or not.
Now, you are metaphorically astride the barbed wire fence. You hedge now and you lock in inflation at an average of 2.7% for 10 years with the implied rates in the previous chart. While this looks attractive, what if there is a recession and inflation returns to near 0% as it did in 2009 and 2020?
Or you could wait and see.
This also comes with a risk of a repeat of the mid-1970s to mid-1980s where inflation ranged from 5% to 14%.
Which leg do I lift first? Do I lift the hedge leg and accept the risk of higher inflation? Or do I lift the risk leg and lock in the current inflation curve? This is a classic barbed wire hedge conundrum where whichever decision you take, there are consequences, and you may wind up in trouble.
Summary
Decisions come with risks, but decisions must be made. The way forward for inflation is not as clear as it has been for many previous years where we had inflation expectations and outcomes around the 2% target. The current expectation is a return to the benign world of approximately 2% in the next year or so. But this may not be the case.
Whether you decide to hedge or not and whichever leg you decide to lift, there may be a time when you quickly need to reverse direction and replace the leg you lifted. To continue the analogy, when you are captured by a barbed wire hedge, take careful note of which leg to lift, manage the risks during and after the operation and be prepared to reverse if things start to go badly wrong.
Otherwise, the outcomes can be painful.