Evolving Investor Expectations

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AT-A-GLANCE

• Bond markets price nearly 6% inflation for 2022 but see it moderating in subsequent years
• Investors see the Fed most likely raising rates past 3% before cutting them back
• Equity investors see slower growth in dividends than they did at the beginning of 2022
• Traders in oil and agriculture see a likely moderation in energy and crops prices
• Options traders see expanded volatility but how much more volatility depends on the product

In financial and commodity markets every price tells a story about what investors implicitly believe is most likely to happen in the future. During the first quarter of 2022, the “market scenario” evolved in important ways in response to economic data and geopolitical events. Below is a summary of the key changes that we have seen across markets.

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The U.S. Treasury issues two kinds of Treasuries: standard nominal bonds and inflation-linked bonds called Treasury Inflation Protected Securities (TIPS). The difference in yields between the two allows one to calculate anticipated inflation and build a year-by-year inflation curve. What this curve shows is that investors have revised their expected pace of inflation for 2022 sharply higher from 3.5% to 5.8 %. While investors views of inflation in 2022 changed dramatically, anticipated inflation for 2023 and beyond have changed little, relatively. Inflation expectations were two-tenths of one percent higher for 2023 and 2024, slightly lower for 2025-27, while long-term inflation expectations (2028-2051) were a few tenths of one percent higher than they had been three months earlier (Figure 1).

Figure 1: Investors expect higher inflation in 2022; long-term inflation expectations are little changed

Expectations for Short-Term Interest Rates

During the first quarter, expectations for short-term interest rates largely followed the evolution of anticipated inflation. At the beginning of the year, the Secured Overnight Funding Rate (SOFR) was positioned to rise towards 1% by the end of 2022 and to 1.5% in 2023 before eventually edging towards 1.75% over the long term. Three months later, that changed to over 3% by the middle of 2023, followed by an easing of monetary policy in 2024 and 2025, with SOFR positioned to settle at around 2.5% over the long term (Figure 2).

Figure 2: Investors now the price the Fed raising rates to over 3% before easing policy circa-2024

CME’s FedWatch Tool, which bases its probabilities for future changes to the Federal Reserve’s (Fed) monetary policy on Fed Funds futures and options prices, suggests a 85% chance that the Fed raises rates by 50 basis points (bps) at their May 4 meeting. If so, that would be their first 50-bps rate increase in 22 years. Moreover, CME’s FedWatch Tool suggests that investors price around a 62% probability that the Fed does three consecutive 50bps rate (or greater) hikes – something that it has not done since 1994.

Perhaps what is most interesting is the dialogue that appears to be going on between investors’ short-term interest rate expectations and their beliefs about future inflation. Part of the reason why investors see long-term inflation expectations as remaining moderate at around 2.25% may be because they see the Fed taking aggressive action to quell inflation in the short term before it takes root and becomes a longer-term problem. Likewise, part of the reason why they see the Fed as being able to potentially ease policy in 2024 and 2025 is because they see long-term inflation expectations as being contained at around 2.25%.

Dividends and Corporate Profits

Annual S&P 500® Dividend Index Futures allow us to peer into investor expectations for corporate cash flows up to 10 years in the future. Over the course of the past three months, investors have become less optimistic about future dividend payments. In January, investors saw dividends as most likely growing by 21% between 2021 and 2031. As of early April, they expect growth of only 12%.

For 2022, however, investors see dividends rising by 6.9%, up from 5% at the start of the year. The higher expectations for dividend growth in 2022 appear to reflect higher anticipated inflation. Adjusted for expected inflation, investors see dividends growing at just 1.3% this year compared to 1.5% real growth at the beginning of 2022 (Figure 3).

Figure 3: Investors price slower dividend growth now than they did at the start of 2022

Perhaps most striking feature of the S&P 500 Annual Dividend Index Futures’ pricing is that investor see slow growth in dividends over the coming decade after a 155% rise in dividend payments in the previous decade. In theory, equity markets discount the value of future cash flows into the present. Despite the relatively pessimistic view of future dividend growth, equity markets are trading close to record highs. This suggests that investors are willing to pay relatively high prices for equities because long-term interest rates remain low because of expectations for inflation to be contained. As such equity market valuations appear to depend on assumptions that inflation and long-term rates will remain low.

West Texas Intermediate (WTI) Crude Oil

WTI Crude Oil futures curve began 2022 in backwardation with May 2022 prices at around $76 per barrel and May 2024 prices at around $66. Russia’s invasion of Ukraine came as a major shock to the oil markets on the scale of Saddam Hussein’s invasion of Kuwait in the summer of 1990. The May 2022 contract recently traded at around $107 per barrel after having traded as high as $126 last month. But prices are declining over the long-term, with May 2024 WTI at around $77 per barrel – higher than where they were at the beginning of the year but significantly below the current month price (Figure 4).

Figure 4: Russo-Ukraine conflict sent oil prices higher, but investors see them most likely moderating

The scenario is similar for agricultural goods. The Russo-Ukrainian conflict sent the prices for wheat, corn, soybeans and soybean oil higher as well, but those markets are also in sharp backwardation, futures indicating a likely moderation of prices ahead. The backwardation in commodity futures jives with investor expectations of inflation: futures are showing prices for crops or crude oil are not expected to last amid expectations for inflation not to remain high either. 

Uncertainty: How Options Traders View the World

Futures curves reveal how investors price the most likely scenario (Figure 5). Options markets compliment this by revealing the degree of certainty with which investors hold their views. Implied volatility on futures options increased almost across the board during the first quarter, but some assets saw much bigger increases in perceived risk levels than others.

Figure 5: Implied volatility showed the largest proportional increase for energy, wheat and 5Y Bonds

Since implied (and realized) volatility varies significantly across asset classes, to measure where perceptions of uncertainty changed the most, we standardized the measure of implied volatility by viewing it as a proportional change. For example, if implied volatility on a given contract was 10% in January and 11% in April, this would show as a 10% increase (11%/10% - 1 = 0.1 = 10%).

The biggest rises in uncertainty (implied volatility) came in the energy complex where implied volatility more than doubled on Ultra Low Sulfur Diesel and rose by 80% for gasoline and 60% for WTI crude oil.  Implied volatility on wheat rose by 70% from its levels at the beginning of year while corn volatility rose by 20%. These changes reflect the role of Russia and Ukraine in the energy, wheat and corn markets. The only major products where implied volatility was lower in early April than it had been in early January was soybeans (and soybean meal). Neither Russia nor Ukraine is a significant exporter of soybeans.

Implied volatility also rose significantly for certain currency pairs notably EURUSD (+50%) and JPYUSD (+60%) but less so for the other currencies. Implied volatility rose sharply for bonds near the middle and shorter end of the yield curve: +60% for 5Y U.S. Treasuries but only +46% for 10Y Treasuries and +28% for 30Y U.S. Treasuries (Figure 5). Finally, options are indicating uncertainty as only marginally higher in early April than in early January, but implied volatility rose much higher for a while in March before coming back down as equities rebounded off their lows. Implied volatility on equities has a strong inverse relationship with price. As such, any sell off in the equity market could lead to a rapid rise in implied volatility on equity index options.

Overall, the message from options investors is to treat the central (most likely) scenarios implied in futures curves with caution. Uncertainty in the world rose during the first quarter, expanding the range of possible outcomes to imply that anything can happen.