Ahead of the upcoming US presidential election next week, interest rate options investors are actively trading in anticipation of potential returns if interest rates remain high, indicating market expectations for a strong Republican victory.
The options market is also preparing for the largest post-election volatility in US Treasury bond yields in over thirty years.
A potential Republican sweep of both houses of Congress and the US presidency could lead to increased tariffs, resulting in higher interest rates, particularly at the back end of the yield curve. The increased supply of US treasuries to fill the substantial fiscal deficit is also expected to push long-term yields higher.
Investors have been buying what are known as long-dated payer swaption options to profit from high interest rates. In these trades, investors purchase the right to pay a fixed rate and receive a floating rate.
Amrut Nashikkar, Managing Director of the Fixed Income Strategy Department at Barclays, stated, “The performance in the options market seems to indicate a higher likelihood of a Republican landslide, with the expectation of rising interest rates and long-term yields.”
However, should the Democratic party win, there could be potential tax increases for corporations and high-income households, which may impede economic growth. The likelihood of slowed inflation could prompt the Federal Reserve to adopt a more aggressive accommodative policy, potentially leading to lower rates guided by the front end of the yield curve.
Swaption options are interest rate options, representing a part of the over $60 trillion over-the-counter interest rate derivatives market. They measure the cost of exchanging fixed-rate cash flows for floating-rate cash flows, and vice versa, allowing investors to hedge against interest rate risks.
Swaptions typically reference the secured overnight financing rate (SOFR) as the benchmark rate, reflecting expectations for interest rates.
Anticipated policy changes are also reflected in swaptions ranging from five to 30 years, where the cost of implied volatility (a measure used to price these options) surged weeks ago as online betting odds on platforms like Polymarket indicated an increase in odds for former Republican President Donald Trump winning the election, despite national polling showing a tight race.
On October 21, the one-month implied volatility for 30-year swaption rates reached a yearly high of 31.06 basis points. By Friday, this figure had decreased to 30.5 basis points.
Nashikkar from Barclays explained, “Due to expectations of increased government debt issuance, long-dated treasuries have traditionally been very sensitive to fiscal policy, with long-term treasuries seeing higher issuance levels.”
Implied volatility for other long-dated bonds (in the 5-10 year range) has also surged.
Bruno Braizinha, Senior Interest Rate Strategist at Bank of America Securities, highlighted that the magnitude of their rise is significantly higher than what was seen during the 2020 election cycle.
As volatility climbs, investors are betting on higher long-term rates, such as the 30-year swaption rates, rising by approximately 50 basis points within a month.
On October 22, the cost of long-term trades soared to an 18-month high of 33 basis points, indicating a growing expectation among investors for a 50-basis point increase in 30-year swaption rates within a month, likely due to potential increases in 30-year treasury yields.
Bank of America’s Braizinha noted, “The worst-case scenario for bonds is a significant reversal, prompting investors to actively hedge and attempt to hedge for their portfolios.”
In addition to the expectations of a Republican sweep of Congress, investors also anticipate a significant 18 basis point swing in bond yields on November 6th or 7th, which is 2.5 times higher than the index’s current forecasted one-month average daily volatility according to the MOVE index.
The MOVE index, a benchmark for interest rate volatility, stood at 128.4 on Friday, indicating an average daily fluctuation of 8 basis points in either direction for most US treasury yields across various maturities within the next 30 days.
Harley Bassman, Partner at Simplify, the creator of the MOVE index, projected substantial volatility in post-election bond yield rates, potentially the largest since known events like the Gulf War in 1991.
He pointed out that interest rate volatility exceeds that of the stock market, with Bassman suggesting that the stock market is now more complacent towards the election. Both former President Trump and Vice President Kamala Harris have proposed substantial increases in budget deficits through increased fiscal spending, which is seen as beneficial for the stock market and economy.
Bassman stated, “Either way, it creates massive deficits, which then create a massive fiscal thrust, ultimately forming a tailwind to drive economic growth.”
(This article referenced reports from Reuters)