Who buys and sells inflation risk
In this paper Bahaj et al. use detailed regulatory transaction-level data on every over-the-counter (OTC) inflation swap contract sold in the UK to analyze who insures against inflation risk. They decompose the price movements into
fundamentals and liquidity shocks. Some of their findings:
- There is “a remarkable segmentation of this market: pension funds barely trade in the short-horizon market while informed traders conduct most of their buying and selling activity in the short-horizon market”
- “In the market prices seem to fully reflect information after one to three days. There is some persistence, so markets are not fully efficient, but they are quite close to it, perhaps because investors in this market are very sophisticated, although subject to different constraints and operating with different beliefs.”
- “The slope of the supply function of dealer banks is close to horizontal at long horizons (but not so at short horizons). Therefore, fluctuations in quantities traded in this market reflect almost entirely liquidity shocks shifting the demand from pension funds”
- “Even though one-year inflation swap prices are sometimes used (amongst other measures) to quantify expected inflation and to guide monetary policy, our estimates suggest that much of the variation in these prices can be explained by liquidity shocks to hedge funds and dealers.”
- “There is significant dispersion in the beliefs about inflation within and between dealer banks and hedge funds. In the short horizon market, a handful of institutions have a large price impact and dominate the formation of prices. In the long horizon market, pension funds have closer beliefs and their price impact is more homogeneous. The beliefs about inflation of dealer banks inferred from trading activity and from surveys line up remarkably well.”
The Market for Inflation Risk
Authors: Saleem Bahaj, Robert Czech, Sitong Ding, Ricardo Reis
From: University College London, Bank of England, LSE
…not the U.S. banks!
In contrast to the research above and consistent with research presented in our newsletter “How do banks hedge?”, in this paper Jiang et al. find evidence of limited inflation hedging by U.S. banks. The authors are using interest rate swaps and not inflation swaps. They looked at call reports data for interest rate swaps covering close to 95% of all bank assets and supplement it with hand-collected data on broader hedging activity from 10K and 10Q filings for all publicly traded banks (68% of all bank assets).
The use of hedging and other interest rate derivatives was not large enough to offset a significant share of the $2.2 trillion loss in the value of U.S. banks’ assets (Jiang et al. 2023). The duration of bank assets increased during 2022, exposing banks to additional interest rate risk. We find slightly less hedging for banks whose assets were most exposed to interest rate risk. Banks with the most fragile funding – i.e., those with highest uninsured leverage — sold or reduced their hedges during the monetary tightening. This allowed them to record accounting profits but exposed them to further rate increases.
Limited Hedging and Gambling for Resurrection by U.S. Banks During the 2022 Monetary Tightening?
Authors: Erica Xuewei Jiang, Gregor Matvos, Tomasz Piskorski, Amit Seru
From: University of Southern California, Northwestern University, Columbia University, Stanford University
