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28 Feb 2023

Eurex Exchange

The return of inflation - here to stay?

Ahead of the Derivatives Forum Frankfurt, Eurex caught up with Thilo Rossberg, head of FICC markets at LBBW, to discuss his outlook for inflation in 2023 and how it will shape fixed income markets.

The return of inflation around the world and central banks’ battle to combat that trend with rate hikes and quantitative tightening marked a reversal in fixed income markets last year, as volatility returned to trading desks. The path for market conditions in 2023 is uncertain though, with some predicting a new era of higher or longer inflation and others seizing on the early signs of disinflation to predict rate cuts. 

The year started with market participants taking differing views on the outlook for inflation, what course do you think it will take this year? 

Central bankers’ view on transitory inflation was maybe causing them to be too passive in the beginning and now they may be frontloading too much on rate hikes. I don't share the view of some in the market that in six months’ time we will see the first rate cuts. On the idea of peak inflation, I think the market is getting it completely wrong.

Yes, we are going to see some disinflation for sure. But markets need to get more used to the idea of inflation lasting a bit longer than half a year’s time.

I see 3-4% inflation for the next one or two years. If that comes true, then the current inversion of the curve is not sustainable and we will have higher rates for quite a bit longer. Now, with the risk of recession being lower than many were predicting three to four months ago, we might even have overshoot from central banks continuing to raise rates.

What affect has the return of inflation had on fixed income markets?

Higher rates spurred interest in fixed income trading last year. In hindsight, it's hard to pin down the main reasons why it was such a high volume year for fixed income trading. Inflation and rising rates were the main driver but fallout from the war in Ukraine and the aftermath of Covid-19, with supply chain disruptions, were also factors.

Trading desks generally did well from the volatility, but conditions were very risky, and some got their fingers burnt. I’m not sure that is a pattern that we will see again in 2023. Certainly, the massive raising of rates is over. There is still an upward trend, but it is slowing down.

One thing we are seeing more of is the data dependency of the market, which may be due to the rising influence of algos. So, we see headline data coming out, then the reaction to that release lasting a day or two or even a week. It has become hard to predict what the next thing will be that really moves the market.

The phasing out of bond buying programs has also has a noticeable effect on the covered bond market, where central banks had been purchasing everything. We are now seeing the need for a secondary market once again and massive primary issuance since the start of the year. This asset class has become very sought after as a refinancing vehicle.

What affect are these conditions having on asset allocation and which products are becoming popular?

We are seeing asset managers shifting their strategies and asset allocations from illiquid alternative investments that gave them slightly positive returns when everything else was negative. Now, they are happy to switch over to good old fixed income investments.

We are also hearing questions that were last asked many years ago around exotic rate structures, a market that had dried up in recent years. Now people are starting to ask questions about steepeners and constant maturity swaps, the kinds of products that remind me of the market 10 years ago.

For inflation derivatives, we have even seen some institutional investors that have no inflation liabilities whatsoever, talking about and actually putting on smaller inflation-linked deals. Sometimes the motivation for that has not been balance sheet hedging but just hedging against the risk of rising operational costs.

These are lively markets, and I am very bullish about conditions in 2023.

Join the Derivatives Forum Frankfurt on 22-23 March to hear more on inflation.


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