Diverging signals in US traded inflation: 5y5y looks cheap, but limited appeal to go long

Overview

This report discusses the repricing of US traded inflation following the decline in oil prices. Goldman Sachs notes that the front end of the inflation swap curve has moved lower most significantly, while longer-dated inflation pricing has also fallen markedly. The 5y5y inflation swap is around 2.38%, close to levels seen during the initial phase of growth concerns following the conflict. The report's core judgment is that near-term inflation pricing is broadly consistent with macro drivers, long-term inflation forwards are relatively cheap versus the model, but the risk-reward profile of going long traded inflation is not compelling at present.

Core views

The report's core view is that the signals are mixed. First, spot inflation swap pricing at maturities such as 5y is broadly close to model fair value. Second, the decline in longer-dated inflation swaps such as 5y5y has exceeded what oil prices and historical macro variables would typically explain, leaving it approximately 10bp below fair value. Third, 1y1y and 2y2y appear expensive, indicating that the market is still pricing the risk of stickier inflation over the next few years. Fourth, even though long-term forwards are cheap, the market-implied inflation path over the next 12 to 18 months remains above Goldman Sachs economists' forecasts, so cheap valuation should not be equated directly with a strong long signal.

Analysis framework

The report constructs a simple macro fair value framework to estimate reasonable levels for inflation swaps across different maturities. The model relies primarily on survey-based consensus forecasts, including one-year inflation and growth forecasts, dispersion in inflation forecasts, expectations for policy changes, long-term inflation forecasts, and oil prices, using data from 2010 to the present. The author also uses model residuals to explain future returns on inflation swaps, finding that when inflation pricing is cheap relative to fair value, going long inflation swaps generally tends to produce positive returns, although this relationship contains substantial noise.

Methodology notes

• Macro fair value modelSurvey-expectations-driven fair value framework for inflation swaps

  Estimate the fair value of the inflation swap curve using survey-based inflation, growth, and policy expectations.

  The report uses one-year consensus inflation forecasts, growth forecasts, inflation forecast dispersion, policy change expectations, long-term inflation forecasts, and oil prices. It argues that survey-based indicators are not directly distorted by liquidity and risk premia and can therefore serve as valuation anchors for market inflation pricing.

• Return signalUsing model residuals to explain inflation swap returns

  The deviation of inflation pricing from model fair value can serve as a signal for future returns.

  Using 5y and 10y inflation swaps as examples, the report finds that model residuals have significant explanatory power for one-year returns. However, realized returns are also affected by actual inflation, equity returns, and changes in interest rates.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• US inflation swaps

  Core research subject

  Strengths

  The survey-expectations model indicates that some long-term maturities are cheap relative to fair value, and model residuals have some explanatory power for future returns.

  Weaknesses

  Return signals contain substantial noise and are jointly affected by actual inflation, risk assets, interest rates, and oil prices.

  Comparison

  Front-end pricing is broadly fair, longer-dated forwards such as 5y5y are cheaper, while 1y1y and 2y2y are expensive.

  Risks

  Inflation below market pricing, weaker growth, or rising real-rate expectations could all weigh on long-inflation returns.

• 5y5y inflation swaps

  Instrument for long-term inflation forward valuation recovery

  Strengths

  Currently approximately 10bp below model fair value and could move toward fair value if Federal Reserve expectations turn dovish.

  Weaknesses

  Cheap valuation does not equal a strong trading signal; going long currently looks more like a scenario hedge than a core allocation.

  Comparison

  Compared with 5y spot inflation swaps, the valuation deviation in 5y5y is more pronounced.

  Risks

  If oil prices decline, spot inflation cools, or the market continues to believe in a hawkish Federal Reserve reaction function, the recovery could be delayed.

• Oil prices

  Important macro driver of inflation pricing

  Strengths

  The oil price curve has greater explanatory power for longer-dated maturities, particularly 30y and 5y5y inflation swaps.

  Weaknesses

  The transmission of oil price shocks to inflation forwards is unstable and is affected by policy expectations and risk appetite.

  Comparison

  Front-end inflation is more sensitive to oil prices and near-term inflation expectations, while long-term forwards are also influenced by long-term inflation expectations and the oil price term structure.

  Risks

  A further decline in oil prices would weaken the case for going long inflation swaps, while another sharp rise in oil prices could push inflation risk premia higher again.

Key data

• 5y5y inflation swapApproximately 2.38%The report says this level is close to that seen during the early stages of post-conflict growth concerns.
• 5y5y relative to fair valueApproximately 10bp belowThe decline in long-term forward inflation has exceeded what historical macro drivers would typically explain.
• Model sample period2010 to presentUsed to estimate fair value relationships for inflation swaps across different maturities.
• Model explanatory powerR-squared approximately 0.82 to 0.84The table shows relatively high explanatory power for the 5y, 10y, 30y, and 5y5y models.
• Key trade horizon12 to 18 monthsThe inflation path priced by the market is above Goldman Sachs economists' forecasts over this forward-looking horizon.

Impact & implications

For investment implications, the report does not deny that long-term inflation forwards have room for valuation recovery, but it places greater emphasis on the conditions that could trigger such a move. If the market reassesses the Federal Reserve's policy path and shifts toward a more dovish stance, or if oil prices rise sharply again due to an escalation of the conflict, long-term inflation forwards such as 5y5y could converge toward fair value. Conversely, if inflation data cools, oil prices decline, or the growth backdrop weakens, cheap valuation signals may be insufficient to support long-inflation performance.

Risks

• Market inflation pricing is above Goldman Sachs economists' forecast for the 12-to-18-month forward inflation path, which could limit the upside for a long position.
• If the Federal Reserve's reaction function is perceived as hawkish, a rise in near-term inflation may be reflected more in higher real-rate expectations rather than an expansion of long-end inflation risk premia.
• The relationship between inflation swap returns and model residuals contains noise, and risk assets, actual inflation, and yield changes could all alter trading outcomes.
• Falling oil prices or cooling spot inflation data could cause the inflation curve to re-steepen and weigh on long-term inflation forwards.

What to watch

• Whether the 5y5y inflation swap recovers from approximately 2.38% toward model fair value.
• Whether Federal Reserve policy expectations shift from hawkish to more dovish, particularly through a repricing of the market's view of the reaction function.
• Whether oil prices and the oil price term structure rise again and drive inflation risk premia higher.
• Whether upcoming inflation data continues to cool or produces an upside spot-inflation surprise.
• Whether 1y1y and 2y2y inflation swaps continue to reflect the risk of persistent inflation over the next few years.