Investors pile into options to bet on rate rise, Treasury weakness

BY Reuters | ECONOMIC | 10/22/20 12:20 PM EDT

By Karen Brettell

Oct 22 (Reuters) - Investors have been buying options on eurodollar futures and interest rate swaps to bet on higher rates and falling U.S. Treasury debt prices if lawmakers pass more fiscal stimulus after next month?s presidential election, if not before.

Investors are betting that eurodollars, which reflect shorter-term rate expectations, could fall in price on a growing expectation of a Federal Reserve rate hike as soon as 2023.

This can be seen in increased demand for put options that pay off when prices fall, and higher implied volatility, a key component of options pricing that rises and falls with demand.

?The very front-end has been awoken from its slumber. There are a number of options trades going through, particularly in the eurodollar space, targeting a tightening of policy in 2023/2024,? said Michael de Pass, global head of U.S. Treasury trading at Citadel Securities.

Short-term rate markets have been moribund for months as the Fed commits to holding rates near zero to tackle economic weakness after businesses shut down to try to stem the spread of COVID-19.

?We were coming off an incredibly low base for implied volatility and that?s ticked up a bit over the last couple of weeks,? de Pass said.

The ICE BofA MOVE index, a measure of Treasury market volatility, has jumped to around 60, from a record low of 37 reached in September. It remains well below the high of 164 reached at the peak of market volatility in March.

The White House and Democrats in the U.S. Congress are in discussions about pumping trillions more dollars into the economy.

Even if a deal is not reached, investors see a jump in spending as likely after the Nov. 3 election, with a larger bill more likely if Democrats win control of the U.S Senate.

Trading volumes in options on Eurodollar futures have jumped to 7.67 million contracts so far this month, more than were traded in each of August and September, though volumes remain lower than earlier this year, data from the CME Group show.

Put options make up 63% of October's activity, up from 42% of volumes in June, and 30% in March, CME data show.

Options referencing Eurodollar futures that mature in 2023 and 2024 also make up 36% of October's total options trading volume, up from 16% in June and only 2% in March, CME said.

Subadra Rajappa, head of U.S. rates strategy at Societe Generale, said there has also been an increase in bearish trades placed in swaptions, or options based on interest rate swaps. Swaps are exchanges of interest rate payments and are used to bet on or protect against a rate change.

?With the rise in yields people are trying to gauge if perhaps we could see an earlier start to Fed rate hikes than what the market?s currently pricing in,? she said.

The predominance of short positions, however, could lead to investors taking profits during any further bout of weakness, which in turn could cap the extent of yield increases, Rajappa said.

Benchmark 10-year yields hit a four-month high of 0.853% on Thursday and five-year yields reached 0.378%, up from a record low of 0.189% in August.

Analysts caution that ongoing economic weakness and global demand for yield could limit any large increase in bond yields.

The Fed is also expected to shift more of its bond purchases to longer-dated debt if it sees yields rising faster than economic growth warrants.

But options are "a cheap hedge,? said Gennadiy Goldberg, an interest rate strategist at TD Securities in New York. Yields ?tend to move in pretty defined patterns in the sense they tend to grind, grind, grind lower, and then they pop higher on something.?

"It's hard to hedge those types of moves and you are only able to do it in the options market," he said. (Reporting by Karen Brettell; ; Editing by Alden Bentley and David Gregorio)

In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible.

Lower-quality debt securities generally offer higher yields, but also involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.

fir_news_article