Updated with data through August 7, 2014
August 7, 2014 [PDF]
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.
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.
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).
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.
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.
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