Conflicting signals from the Federal Reserve regarding U.S. interest rate cuts have spurred increased hedging activity in swaptions and overnight rate derivatives. Investors are seeking protection against potential policy uncertainty. Swaptions, a segment of the over $600 trillion over-the-counter rate derivatives market, are options on interest rate swaps, which allow investors to hedge interest rate risk, including exposure to Treasury securities. Rate swaps measure the cost of exchanging fixed-rate cash flows for floating-rate ones, or vice versa.
Short-term volatility in longer-dated swaptions, particularly those on 10-year and 30-year swaps, has increased after a period of compression. Open interest in options linked to the Secured Overnight Financing Rate (SOFR) expiring within the next quarter has also climbed. SOFR represents the cost of overnight borrowing for short-term cash, primarily secured by Treasuries, and aligns with the Fed’s policy rate.
Analysts note that hedging activity remains balanced, covering potential outcomes from the Fed’s upcoming meeting. Signals from some U.S. central bank officials, including New York Fed President John Williams and Governor Christopher Waller, suggest a possible December rate cut due to labour market weakness. This contrasts with other regional Fed presidents advocating a pause until inflation convincingly approaches the 2% target.
U.S. rate futures now indicate an 85% probability of a Fed rate cut in December, up from 50% the previous week, according to CME’s FedWatch tool. Data from the Commodity Futures Trading Commission shows U.S. swaption volume rose to $887 billion in the week ending November 7, about 18% higher than the week prior, suggesting heightened demand for protection against sharp market movements.
