Weekly Commentary on Future Asset Values

Updated with data through August 7, 2014

Latest Report

August 7, 2014 [PDF]


Commentary

Risk-neutral expectations for inflation rates dropped again last week and the market bias toward higher short-term rates (LIBOR) two and five years ahead remains in place. Equity markets were weak and tail risks embedded in equities rose. Most spot prices in the commodity markets we follow dropped last week with the exceptions of wheat and cattle. 

Inflation
The median (risk-neutral) expected inflation rate over the next twelve months, as derived from caps and floors on the CPI, continued the decline since our last report and is now below 2%. Trends are similar for the two year horizon where the median risk-neutral expectation is 2% (top chart below).

Market participants’ uncertainty about these expectations is decreasing. The dispersion of potential outcomes continues to narrow as shown by the trends in the interquartile ranges of the MPDs (blue line in the bottom chart below).

Finally, at the one and two year horizons, the recent increase in bias towards higher inflation expectations has subsided. This is shown by the change in the quantile skew which measures the difference in risk-neutral probability above and below the mean (red line in the bottom chart below). One year horizon data is included in the chart package.

Chart 1

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Chart 2

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LIBOR Rates
A bias remains toward higher rates as measured by MPD skew. Risk-neutral probabilities for a 100 basis point increase two years out continue to rise slowly (top chart below). Risk-neutral probabilities for large rate changes five years hence remain relatively stable (bottom chart below).

Chart 3

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Chart 4

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Banks & Insurance Companies
Over the past two weeks the equity market experienced a significant selloff with the S&P 500 dropping approximately -4%. The average share price of our CCAR 17 banks fell -4.9% and the average of our eleven insurance companies fell -4.8%. Trading was relatively active last week for options on the S&P 500 index as well as for the banks and insurance companies.

MPD standard deviations spiked since our last report. In particular, bank MPD standard deviations are at the high end of their 20 week ranges. MPD skews, which measure risk-neutral expectational bias toward higher or lower prices, generally increased suggesting increased expectation for a bounce-back in prices. This was true for both bank and insurance company MPDs.

Chart 5

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Chart 6

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Additional Details:

  • While trading in options on shares of KEY was light, its MPD skew became more negative as its share price fell indicating increased risk-neutral expectation for continued downside price moves. (See KEY report.)
  • Trading in options on shares of RF led to similar changes in its MPD. Different from KEY was that trading activity was relatively strong for options on RF shares. (See RF report.)

Chart 7

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Chart 8

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Other Commodity Markets
Spot prices were generally lower with the exceptions of wheat (+5.2%) and gold (+1.6%). Trading was strong for options on futures for wheat, silver, and each of the exchange rates. Trading in options on the S&P 500 index was also strong and equity market tail risks jumped.

Additional Details:

  • Since the beginning of the year, the demand for downside protection on the S&P 500 has increased relative to last year. The proportion of options trades at lower strike prices is higher and continues to grow as the year progresses. The chart below accumulates volumes for trades occurring at each strike price for 2013 and 2014.

Chart 8

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  • Tail risks, as measured MPD standard deviations derived from options on futures prices, were higher relative to two weeks ago for wheat and cattle. Notably, the MPD skew for wheat, which indicates the market participants’ price bias, also jumped. (See wheat and cattle reports.)

Chart 8

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Narayana Kocherlakota