UBS Inflation-Linked Strategy - Euromoney Conferences

UBS Inflation-Linked Strategy 

Chris Lupoli, Strategist 

Executive Director : Global Inflation-Linked Strategist 

+44-20-7567-7589 

chris.lupoli@ubs.com 

February 2010 

Analyst certification and required disclosures begin on slide 22 

This material has been prepared by UBS Limited

Table of contents 

SECTION 1 TIPS should now trade cheap to fair value 2 

SECTION 2 Inflation-linked strategy views in 2010 8 

APPENDIX UBS inflation-linked strategy and resources 13 

1

SECTION 1 

TIPS should now trade cheap to fair value

TIPS should now trade cheap to fair value 

It is important to know who is the price setter in the market 

Fair 

value 

Idealised view of a market dominated 

by mean-reverting type investors 

Mean-reverting price action, with average close to fair value 

Average marginally below fair value 

♦ Non mean-reverting investors (buy-side 

portions of the real money universe, e.g. 

passive fund managers and real rate based 

investors) are generally buyers of the market 

♦ This implies that the market will trade 

‘cheap’ to fair value as these investors will 

only buy below fair value… 

♦ …and take profit as we approach fair-value 

Source: UBS 

♦ Mean-reverting type investors (leveraged, 

proprietary desks, active fund managers, 

etc.) want the market to trade at fair 

value and then ‘play the range’ 

♦ Essentially the mean-reverting investor is 

selling volatility, therefore creating 

‘stability’ in the time series 

♦ This leads to a self re-enforcing feedback 

loop being established 

Fair 

value 

Idealised view of a market dominated by 

non mean-reverting type investors 

Mean-reverting price action, with average close to fair value 

Average below fair value 

3


What is the ‘fair value’ for our product? 

Philly Fed Survey of Professional Forecasters see 10-year ahead US CPI 

at around 2.5% 

3.75% 

3.50% 

3.25% 

3.00% 

2.75% 

2.50% 

2.25% 

2.00% 

10-year TIPS BEIs were around 3% when 

first issued in 1997 

Q1-94 Q1-97 Q1-00 Q1-03 Q1-06 Q1-09 Q1-08 

Philly Fed Survey of Professional Forecasters: CPI over next 10-years; median (% ) 

♦ We make use of the Philadelphia Fed’s Survey of Professional Forecasters that has a long-running 

10-year ahead US CPI question…has been around 2.5% for more than a decade, so we use this as 

our concept of fair value 

Source: Federal Reserve Bank of Philadelphia, Haver Analytics, UBS 

10-year ahed CPI expectations have 

effectively flat-lined at 2.5% since late 1998 

4


How important is the breakeven? 

Breakeven (%) 

Generic 10-year TIPS breakeven history 

3.5 

3.0 

2.5 

2.0 

1.5 

1.0 

0.5 

0.0 

-0.5 

Non mean 

reverting 

environment 

97 98 99 00 01 02 03 04 05 06 07 08 09 10 

♦ In inflation-linked space there is an additional factor : the breakeven rate is a perfect vehicle for 

mean-reversion type trading 

♦ While mean-reverting investors are almost entirely focused on the breakeven variable, non-mean 

reverting are focused on both the breakeven and real yield. For example, long-term liability 

investors can be seen to be real return focused and hence will invest primarily based on the real 

yield level 

♦ Higher TIPS turnover equates to dominant involvement by leveraged investors (i.e. mean-reverting 

type investors); whereas lower turnover environment reflect real money based investors being in 

the ‘driving seat’ 

♦ In our view, we are back into a non mean reversion environment and hence 10-year TIPS 

breakevens should, on average, trade cheap to fair value (i.e. around 2% rather than 2.40%) 

Source: Bloomberg, UBS 

Mean reverting 

environment 

Generic 10y TIPS BEI 

? 

5% 

4% 

3% 

2% 

1% 

0% 

Turnover data for TIPS (uplifted basis) 

98 99 00 01 02 03 04 05 06 07 08 09 10 

Turnover per uplifted amount outstanding (face amount x IR), 

8-week avg 

5


Supply-demand balance could be an issue in the near future 

Relationship between gross Treasury issuance (lagged one year) and TIPS issuance 

160 

140 

120 

100 

80 

60 

40 

20 

0 

FY 96/97 

FY 97/98 

FY 98/99 

FY 99/00 

♦ Significant demand for TIPS in 2009 came from retail (e.g. surge in size of ETF and TIPS mutual 

funds). However, we see constraints to this demand in 2010, probably triggered by likely 

negative year-to-date returns on TIPS funds…this could provide a problem for the market to 

meet the likely TIPS demand 

♦ Two potential buyers: (a) long-term liability managers (e.g. private and even public pension 

schemes), and (b) the re-emergence of mean-reversion type investors 

Source: Haver Analytics, Bloomberg, UBS 

FY 00/01 

FY 01/02 

FY 02/03 

FY 03/04 

FY 04/05 

FY 05/06 

FY 06/07 

FY 07/08 

FY 08/09 

FY 09/10 

FY 10/11 

2,000 

1,750 

1,500 

1,250 

1,000 

Gross TIPS issuance (Bil.$) Gross Issuance (notes, bonds incl. TIPS) (Bil.$) FY lagged 1Y - RHS 

750 

500 

250 

0 

6


Two ways this can change 

1. The ‘fair value’ shifting higher once again 

♦ This would reflect an aggregate increase in investor concern about inflation; we 

would argue that there remains a polarised lobby within the investor base. 

♦ Further, the economic recovery is still not strong enough to justify excessive 

inflationary concerns (especially with the current slack in the labour market). 

♦ Hence, near-term we see the 2.5% US CPI ‘fair value’ concept as being justified 

♦ Nevertheless, we are in the inflation camp and hence can see a move higher in the 

fair value at some stage in the future 

2. Mean-reverting type investors come back into the market 

♦ This occurred in the previous economic cycle (2004). In our view this was driven by 

a) increasing liquidity in the inflation-linked bond asset class 

b) breakevens cheap to fair value in the prior years (1999-2003). So the 

cheapening of breakevens to fair value can be seen as almost a pre-condition 

for these investors to return – this could well be the story at some stage this 

year, but no yet 

7

SECTION 2 

Inflation-linked strategy views in 2010

Inflation-linked strategy views in 2010 

Bubble, bubble… 

S&P 500, last recession and now – very 

similar scenarios, but at a faster pace 

1600 

1400 

1200 

1000 

800 

600 

S&P 500; normalised (1-Jan-99 to 27-Mar-07) 

Source: Haver Analytics, Bloomberg, UBS 

1700 

1500 

1300 

1100 

900 

700 

500 

S&P 500; normalised (26-Oct-06 to date) time scaled 1.73 times - RHS 

History for the last 10-years of CPI-U, 

ex-energy and energy 

6% 

4% 

2% 

0% 

-2% 

-4% 

01 02 03 04 05 06 07 08 09 10 

CPI-U (nsa) -% CPI-U (nsa) ex -Energy -% 

CPI-U (nsa) Energy -% 

60% 

40% 

20% 

0% 

-20% 

-40% 

Real Fed Funds ( Fed Funds minus core PCE) 

Real Rates ( 

6 

5 

4 

3 

2 

1 

0 

-1 

-2 

86 88 90 92 94 96 98 00 02 04 06 08 

Real Fed Funds 

Annual volatility of the residual term following the 

removal of both trend and seasonality from 

inflation time series 

0.8 

0.7 

0.6 

0.5 

0.4 

0.3 

0.2 

0.1 

0 

85 88 91 94 97 00 03 06 09 

Core Headline Energy 

7 

6 

5 

4 

3 

2 

1 

0 

9


Breakeven volatility should be higher than real yield volatility 

Historical realised volatility for 10-year generic real yield and breakeven 

Quarterly st.dev of daily change (bp) 

14 

12 

10 

♦ Uncertainty of CPI outlook should imply a greater volatility for breakevens than real yields. If we 

add in the concept of non mean-reverting investors being currently dominant in the 

market…then the volatility relationship between 10-year breakevens and real yields should be 

more like 1999-2003 

♦ This also suggests an increased focus on beta trading: being dynamic with the nominal hedge on 

a breakeven trade 


8 

6 

4 

2 

0 

Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 

Real yld vol BEI vol 

10


We prefer to be defensive on 10-year TIPS breakevens 

♦ We express this in three ways: 

1. Look for 10-year TIPS breakevens to average closer to 2% than the recent highs at 2.4% 

2. Shorten out of 10-year TIPS into 5-year TIPS breakevens 

3. Prefer to switch out of 10-year TIPS breakevens into Euroland breakevens (e.g. Bundei 10s) 

UBS Economists expect a sharp reversal in the 

US CPI-U nsa versus EU HICPxTob YoY 

differential through 2010 

2.5 

2.0 

1.5 

1.0 

0.5 

0.0 

-0.5 

-1.0 

-1.5 

-2.0 

02 03 04 05 06 07 08 09 10 

US CPI-U NSA minus EU HICPxTob, YoY differential (percentage points) 

UBS Economics forecasts 

Source: Bloomberg, UBS (including UBS Economists forecasts) 

100 

50 

0 

-50 

-100 

-150 

-200 

10-year generic US TIPS-OATei breakeven 

differential 

02 03 04 05 06 07 08 09 10 

10-year generic TIPS - OATei breakeven differential (annualised) (bp) 

? 

11

Breakeven (%) 


Australia’s back on the map: really a breakeven story 

4.5 

4.0 

3.5 

3.0 

2.5 

2.0 

1.5 

1.0 

0.5 

0.0 

Australian TIBs breakeven history 

04 05 06 07 08 09 10 

BEI ACGB 4 8/15 BEI ACGB 4 8/20 BEI ACGB 3 9/25 

♦ The AOFM recommenced issuing inflation-linked bonds (TIB 2025) in 2009. On-going liquidity 

provided by tenders in each of the issues. International focus: should not be viewed as merely 

part of the ‘tracking error’ for global linker managers 

♦ Positive breakevens, but look for ultimately higher real yields due to economic rebound and the 

liquid natural gas story 

♦ Important near-term issue is the Henry Tax Review 


Real yield (%) 

4.0 

3.5 

3.0 

2.5 

2.0 

1.5 

Australian TIBs real yield history 

04 05 06 07 08 09 10 

ACGB 4 8/15 Govt ACGB 4 8/20 Govt ACGB 3 9/25 Govt 

12

APPENDIX 

UBS inflation-linked strategy and resources

UBS inflation-linked strategy and resources 

The Real Deal 

♦ Our flagship weekly publication 

♦ Covering the main ILB markets 

♦ Key views and themes updated 

♦ Trade-idea focused (history included) 

♦ Also showcases inflation input from… 

♦ …UBS Economics teams… 

♦ …other UBS strategy groups 


Screen-shot of a recent The Real Deal 

14


Linker auctions 

♦ Covers upcoming auctions 

♦ Highlights near-term trends in respective markets 

and our views 

♦ Considers relative value of the auction bond 

♦ Valuation of new issues 

♦ Benchmark indices duration extensions 


Screen-shot of a recent Linker auctions 

15


Headlines 

♦ Rapid-response publication 

♦ Focusing on important near-term issues that cannot 

wait for the weekly 

♦ Changes to UBS inflation profiles 

♦ Country-specific focus, e.g. TIPS Headlines 


Screen-shot of a recent TIPS Headlines 

16


Quarterly Inflation-Linked Themes 

♦ Our flagship quarterly publication 

♦ Giving our base-line views on each market 

♦ Thematic approach 

♦ Considering important issues 


Screen-shot of a recent ‘QuILT’ 

17


INFU – UBS inflation-linked trading and strategy on Bloomberg 

♦ INFU to reach the UBS Inflation-Linked Trading and Strategy page on Bloomberg 

Source: Bloomberg 

18


What you can find on INFU 

Type 1 for zero-coupon inflation swaps Type 6 for UK IL prices and asset swaps 

♦ Click on page number to see relevant market levels from the UBS trading desk 

♦ Or press Go, to see the UBS Inflation-Linked Strategy page 


19


UILR 

♦ UILR to reach the UBS Inflation-Linked Strategy page on Bloomberg 


20


What you can find on UILR 

Type 1 for ‘The Real Deal’ Type 2 for ‘Headlines’ 

♦ Select required and then proceed to launch article in pdf format 


21

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recommendations or views expressed by that research analyst in the research report. 

22

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23

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Issuer Name 

2, 4 

Commonwealth of Australia 

Federal Republic of Germany 

2, 4, 16a, 16d 

France 

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Greece 

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Kingdom of Sweden 

2, 4, 5, 16c, 16d 

Republic of Italy 

United Kingdom of Great Britain 

United States 

Source: UBS; as of 24 Feb 2010. 

2, 4, 16b, 16d 

1, 2, 4, 5, 16d 

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