Inflation dispersion increases market opportunities and trading

Trading opportunities will increase with inflation uncertainty. When we say inflation uncertainty, we mean the spread of opinions concerning expected inflation across investors. The gap between the highest and lowest inflation forecast versus the median has grown with the debate between long-term and transitory inflation. The mean long-term forecast for inflation may still be relatively "behaved" at slightly greater than 2 percent, but all of the investment action will be associated with bets on the wings of the distribution and with bets on the inflation time path. 

Inflation uncertainty distorts price signals. Hence, there is less clarity on how to price products. This will lead to mistakes that impact investment decisions. Inflation dispersion will lead to larger allocation changes across asset classes. For example, inflation dispersion will create more switching between equities and bonds. 

Look at the time series of inflation surprises. The dispersion in inflation announcements will create more activity in the wings of  inflationary expectations even if the mean or median inflation look relatively stable.

Take the simple example of the relationship between bonds and inflation. Nominal yields are associated with a real yield, expected inflation, and term/risk premia. If expected inflation is more uncertain, then there will be a corresponding increase in nominal yield uncertainty. We will see this is the MOVE bond volatility index. It increased sharply earlier this in part with the unanticipated inflation shocks. We will also see a change in risk premia and flows as portfolios adjust based on changing inflation perception.

What this dispersion means for trading, across the board, is that rate options associated with sooner Fed action, higher inflation, a change in transitory inflation, and the potential for an extreme inflation move will offer strong return opportunities. Trades can be formed on multiple dimensions which are more complex than just saying that inflation is moving higher or lower.