The volatility market shows investors see a sour global economic outlook, with hedges against a prolonged U.S. downturn and options bets on negative Federal Reserve rates.

Options on dollar-swap rates are highlighting market fears of bond yields remaining lower for longer, even after the Fed signaled a pause in cutting interest rates. That is adding to concerns policy makers are not doing enough to combat slowing growth, supporting long-end bonds.

Traders are pricing in greater volatility on a rally in rates markets. It’s become more expensive to position for a fall in yields than if they rise, reflecting the hedges against economic troubles. This is typical in the late stages of an economic cycle.

  • The skew in the rates volatility world arises from expectations of the relationship between volatility and forward rates, and protection demand against higher or lower yields
  • Low-strike receiver implied volatilities are higher than at-the-money implied vols
  • A similar skew inversion was seen in EUR rates during the summer when bonds aggressively rallied, but has pared following the recent unwind of the overshoot in yields to the downside
  • There is also a log-normal effect with USD vols in the case that the Fed becomes explicit that they won’t take policy rates negative, which would see implied volatility fall when rates are close to zero
  • The terminal P&L of a swaption skew trade held to expiry is essentially a function of the difference in vols bought and sold and the move in the underlying
  • In a downturn, the Fed would likely reintroduce forward guidance and additional asset purchases before adopting negative policy rates
  • There would be potential technical issues to resolve with negative rates from settlement, issues for money-market funds to U.S. Treasury issuing bills above par, as well as the damage to bank profitability due to the cost on excess reserves and the pressure on net interest margins, as seen in Europe
  • Still, demand for options that pay out on negative rates has been on the rise, seen in the increasing open interest on 100 strike call options for eurodollar future contracts, and a three-month Libor rate at zero would more than likely equate to negative money-market rates

This article provided by Bloomberg News.