FILE PHOTO: US dollars are counted by a banker counting the currency at a bank in Westminster, Colorado on November 3, 2009. REUTERS / Rick Wilking / File Photo
October 22, 2020
By Karen Brettell
(Reuters) – Investors have bought options on Eurodollar futures and interest rate swaps to bet on higher interest rates and falling US Treasury bond prices if legislators put more fiscal stimulus after next month’s presidential election, if not before.
Investors are betting that Eurodollars, reflecting short-term interest rate expectations, could fall in price as early as 2023 due to growing expectations of a rate hike by the Federal Reserve.
This is reflected in increased demand for put options, which pay off when prices fall, and in higher implied volatility, a key component of option prices, which increases and decreases with demand.
“The front end was awakened from its sleep. There are a number of options deals, particularly in the Eurodollar space, aimed at policy tightening in 2023/2024, ”said Michael de Pass, global head of US treasury trading at Citadel Securities.
Short-term interest rate markets have been dying for months as the Fed pledged to keep interest rates near zero to combat economic weakness after companies shut down to contain the spread of COVID-19.
“We had an incredibly low base for implied volatility and that has improved a bit over the past few weeks,” said de Pass.
The ICE BofA MOVE index, a measure of the volatility of the Treasury markets, rose from a record low of 37 to around 60 in September. It remains well below the 164 high that was hit at the height of market volatility in March.
The White House and the Democrats in Congress are debating pumping trillions more dollars into the economy.
Even if no agreement is reached, investors see a spike in spending as likely after the November 3 election, with a bigger bill more likely if Democrats gain control of the U.S. Senate.
The trading volume in options on Eurodollar futures rose to 7.67 million contracts this month, more than in August and September, although the volume is still lower than it was earlier this year, according to the CME Group.
Put options account for 63% of activity in October, down from 42% of volume in June and 30% in March, CME data shows.
Options referencing Eurodollar futures maturing in 2023 and 2024 also account for 36% of total options trading volume in October, up from 16% in June and just 2% in March, CME said.
Subadra Rajappa, head of US interest rate strategy at Societe Generale, said declining swaptions or options based on interest rate swaps have also increased. Swaps are the exchange of interest payments and are used to bet on or protect against a change in interest rates.
“As yields go up, people are trying to judge whether we might see the Fed starting rate hikes earlier than the current market price,” she said.
However, the preponderance of short positions could result in investors taking profits during further weakness, which in turn could limit the magnitude of yield increases, Rajappa said.
The benchmark’s 10-year returns hit a four-month high of 0.853% on Thursday, and five-year returns hit 0.378% after a record low of 0.189% in August.
Analysts warn that ongoing economic weakness and global demand for yields could limit any sharp rise in bond yields.
The Fed is also expected to shift more of its bond purchases to longer-term debt if yields rise faster than economic growth warrants.
But options are “cheap hedging,” said Gennadiy Goldberg, interest rate strategist at TD Securities in New York. Yields “tend to move in fairly defined patterns in the sense that they tend to grind, grind, grind lower, and then pop onto something higher.”
“It is difficult to hedge these types of moves and you can only do that in the options market,” he said.
(Reporting by Karen Brettell; Editing by Alden Bentley and David Gregorio)
This article originally appeared on www.oann.com