US hard landing bets rise in rate options market after Fed hikes

Investors in interest rate options are paying for trades that benefit from a sharp slowdown in the US economy, contrary to the upbeat outlook held by many bond market participants. Analysts said they have seen increased demand from hedge funds in the US options market for so-called "receiver swaptions," a type of trade that pays off when interest rates fall. In general, receiver swaptions give buyers the right to enter into an interest rate swap where they receive the fixed rate and pay the floating one.

Swaptions, which are options on interest rate swaps, are one segment of the more than $600 trillion over-the-counter interest rate derivatives market. Rate swaps measure the cost of exchanging fixed-rate cash flows for floating-rate ones, or vice versa. Investors use swaps to hedge interest rate risk.

Receiver swaptions typically reflect concerns about the US economic outlook, analysts said. This is the opposite of "payer swaptions" where investors buy the right to pay fixed and receive a floating rate, benefiting when rates rise as the Federal Reserve tries to slow a robust economy.

"From a macroeconomic standpoint, risks are roughly balanced between a hard landing and no landing," said Bruno Braizinha, interest rates strategist, at BoFA Securities in New York, referring to economic scenarios that reflect contraction and strong growth.

"But the options market is pricing those probabilities more skewed towards a hard landing," he added. Receivers were notable on shorter tenors, analysts said, such as the one-year at-the-money options on one-year swap rates , that part of the curve in which Fed policy is being priced.

Asset managers, on the other hand, are hedging scenarios where the economy stays resilient and interest rates stay higher for longer, Braizinha said. In this case, fund managers have been buying payer swaptions.

Overall, the soft landing scenario is still the majority view, analysts said, but the hard landing case is gaining momentum. A soft landing or no landing has been the predominant view after a slew of data that showed the US economy remained stable despite being subjected to a historically aggressive Fed tightening.

Jeff Klingelhofer, co-head of investments at Thornburg Investment Management in Santa Fe, New Mexico noted that a hard landing for the US economy is a reasonable expectation having gone through the Fed's ultra-tight monetary policy.

"Just textbook economics: Higher rates mean the bar for future demand is tougher. And because a recession hasn't come to fruition at this point, a lot of investors are quickly pivoting to, well, it's not going to happen. I think that's a mistake," said Klingelhofer.

He added that while there have been pockets of strength in some economic data, the majority of these numbers suggested that a slowdown is indeed occurring.

VOLATILITY

US implied volatility or "vol" on swaptions has stabilized a little bit from high levels seen at the beginning of the year, but it remains elevated compared to numbers in November last year. Implied vol measures how much the options market believes interest rate swaps will move in either direction over a given time frame.

Option demand for hedging or speculative purposes tends to lift vol. The higher the vol, the greater the perceived instability over a given period. For instance, volatility on shorter-dated swaptions such as the three-month expiry on one-year swap rates, which reflect near-term uncertainty, was 36.03 basis points (bps) on Tuesday. That's down from 40 bps seen around mid-January, but higher than the level hit in late November of about 33 bps.

US vols are also higher than in the euro zone where a slowdown is already underway. Gross domestic product growth for the region was flat in the fourth quarter after a 0.1 per cent contraction in the third.

Implied vol on Europe's three-month options on one-year swap rates was 26.6 bps on Tuesday, , down from late January when vols were at 31 bps. Amrut Nashikkar, managing director, fixed income strategy, at Barclays in New York attributed higher US vols relative to Europe to the difficulty in assessing the restrictiveness of Fed policy.

"US data has not evolved on the broad front given the big upside surprises," Nashikkar said."In Europe, the ECB (European Central Bank) raises rates and Europe hits a slowdown. In the US it's much harder to put a firmer bound on it and that's why we have this fear of a big shock."