Bond investors, unsure about Fed policy outlook, hedge against US rate shock

That said, Barclays' Nashikkar pointed out that demand has also emerged for positions that benefit from falling rates, underscoring uncertainty over the path of Fed policy. BNP's Dhingra said positioning in shorter-dated options appears relatively balanced between bets on higher and lower rates, consistent with the Fed's data-dependent approach. Further out the curve, however, demand remains skewed toward trades that would benefit from higher rates. "That tells you the market still thinks the long run path for rates is higher," he said. Dhingra further cautioned against reading too much into the most extreme trades, such as options tied to 6% rates, noting they can serve a range of purposes from portfolio hedges to outright speculation. Still, options market activity indicates concern that borrowing costs could stay elevated, with investors increasingly focused on guarding against a wider range of scenarios as the outlook for interest rates becomes harder to predict. Bond investors, uncertain about the outlook for Federal Reserve tightening, have been paying more to protect against the possibility of a sharp rise in U.S. interest rates. U.S. financial markets are grappling with questions about whether new Fed Chair Kevin Warsh will keep the central bank focused on containing inflation, which could require rate hikes, or bow to President Donald Trump's repeated calls for rate cuts. Activity in the interest rate options market has shifted in recent months, with growing demand for a specific type of swaption, or an option on interest rate swaps, that would profit if long-term borrowing costs rise. Some are hedging against the 10-year swap rate reaching 6%, more than 200 basis points higher than today's 4.23% level. For that to happen, the Fed would have to sharply hike the federal funds rate. Interest rate swaps are widely used to hedge rate risk, including exposure to U.S. Treasuries. These swaps allow investors to exchange fixed-rate payments for floating rate ones and vice versa. Analysts say the market has moved away from strategies in which investors collect premium by selling volatility and toward buying protection against large interest rate moves. The shift reflects not only concerns about further Fed tightening but also broader worries that long-term yields could keep rising regardless of near-term policy decisions, driven by factors such as persistent inflation and large government borrowing needs. "The market has become more convinced of rate hikes and you're seeing that in the options market in terms of more demand for payers over receivers," said Guneet Dhingra, head of U.S. rates strategy at BNP Paribas in New York. Payer swaptions, which give investors the right to pay a fixed rate and receive a floating one, typically gain favor when markets expect higher rates. Receiver swaptions, which give investors the right to receive fixed and pay floating, generally reflect expectations that rates will fall as the Fed responds to a weaker economy. Morgan Stanley U.S. rates strategist Shaun Zhou said he has seen a steady increase since May in purchases of options linked to 10-year swap rates USDSROIS10Y=TWEB with strikes above 6%. The buyers of these options would benefit if they hit or go above the strike price. The activity has been concentrated in two- and three-year options on 10-year swap rates USDSR2YX10YATM=R, USDSR3YX10YATM=R, he said, with their premiums rising sharply, particularly in June. While some could view such positions as bets on aggressive Fed tightening, Zhou said they are more likely insurance against a low probability but potentially damaging surge in long-term borrowing costs. "These are not particularly efficient ways to express a normal Fed view," Zhou said, arguing that the trades are better understood as tail-risk hedges for investors exposed to a sharp rise in yields. The size and frequency of the trades, however, suggest institutional investors are seeking protection against outcomes that may be unlikely but cannot be ruled out, he added. Ahead of the Fed meeting this week, volatility in shorter-dated swaptions, including one-year at-the-money options on one-year swap rates USDSR1MX1YATM=R, rose for a fifth straight session on Thursday, before slightly dipping to 20.06 basis points on Monday, suggesting investors are preparing for a larger-than-expected policy move in either direction. "A big move now seems more likely than not and is a potential risk to the short gamma trade, which has been increasingly popular of late," said Amrut Nashikkar, head of derivatives strategy at Barclays. The short gamma trade is a volatility-selling strategy that bets on markets remaining relatively calm. That trade, however, loses money when rates move sharply. U.S. rate futures on Friday priced in a 36% chance of a rate increase at this week's meeting, up from 13% a week earlier.

Bond investors, unsure about Fed policy outlook, hedge against US rate shock

Market remains split on the path for rates

Bond investors hedge against higher U.S. rates

Demand for protection against a surge in swap rates

Short-dated volatility rises ahead of the Fed meeting

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