By Gertrude Chavez-Dreyfuss

NEW YORK (Reuters) – Investors in U.S. interest rate options are paying for trades that benefit from a much earlier-than-expected monetary tightening by the Federal Reserve to fight off stubbornly high inflation, including multiple hikes from next year until 2023.

These bets have increased volatility on U.S. Swaptions. This is an option on interest-rate swaps that gives the buyer the ability to enter future swap contracts at a price pre-agreed.

Investors often use swaps to show their views about where borrowing costs are going.

One-year forward rates on U.S. bilateral swaps were at 1.27% on Thursday. This is compared to the 0.639% spot rate.

Here’s a graph of the US Swap Rates:

https://fingfx.thomsonreuters.com/gfx/mkt/zgpomrxgbpd/US%20swap%20rates1.PNG

The forward rate indicates a 60-basis-point selloff in U.S. 2-years swaps which pushes rates higher. Analysts stated that this ambitious outlook suggests that there will be two rate rises in the next year.

Bruno Braizinha (senior rates strategist at BofA Securities, New York) stated that “the selloff in front end has been priced in very mechanically by the Fed.” “The (swap rate selloff) implies a series of increases that are being front-loaded.”

Futures of the Fed Funds Rate, which are short-term rates expectations, fully price in a quarter point tightening by July 2022. They also factor in another rate rise by December.

Inflation expectations have been rising based on key indicators and higher oil prices. This has fueled what analysts consider an optimistic rate outlook.

U.S. Treasury Inflation Protected Securities 5 year breakeven inflation rate, which is based on market-based inflation expectations for the next five years, reached its highest point since at least January 2004. The U.S. 10-year breakevens reached higher levels than the 15-year highs.

“There’s been a shift in how people perceive the Fed handling inflation. The market used to have a great faith and certainty that even rising inflation would not cause the Fed’s rate hikes. Amrut Nashikkar is the managing director of the Fed and senior rates strategist. Barclays New York, (LON:).

The market believes that the Fed might be sensitive to inflation’s realizations. This creates uncertainty regarding the course of Fed hikes,” said he.

VOLATILITY OF RISING INTEREST RATES

Cboe Interest Rate Swap Vol Index, which measures market stress and uncertainty at interest rates markets, based on data from broker swaptions, reached a record high of 83.03 this Thursday.

Cboe rate vol index

https://fingfx.thomsonreuters.com/gfx/mkt/klpykzywbpg/Cboe%20rate%20bold%20index1.PNG

The volatility of shorter-dated swaptions like one-year at the money options on oneyear swap rates (the part of Fed policy being priced) rose to 73.8 basis point on Thursday from 58.1 basis points two weeks earlier.

Volatility surged in tandem with rising Treasury yields. After the Fed’s September meeting, it indicated that the Fed would likely reduce its monthly bond purchases starting in November. It also hinted at interest rate increases.

U.S. 10-year yields on U.S. bonds have increased by more than 20% since September’s meeting and reached an all-time high of 1.7% in the first five months.

As volatility rose, traders stated that swaptions were a popular way to trade the market. They used swaptions for short-term rates bets by using two-year swap options and paying “high payer strikes”, which are two-year swap options. The structure indicates a Fed increase in rate faster than market expectations. Only if the swap rate reaches the “high strike”, October 2022, the buyer will be able to benefit.

For example, investors have placed a 25-basis point “high strike” above the U.S. 2-year forward rate of 1.277%. This is a too optimistic goal for many market participants.

GennadiyGoldberg, senior rates strategist at TD Securities, stated that there is a reason why the Fed’s actions are being priced aggressively by the markets. They see central banks all over the globe raising interest rates and becoming hawkish. This is why they are drawing parallels to the U.S. thinking that the Fed might do the same.

Bank of England, Bank of Canada and Bank of England have indicated that rate increases are likely sooner than anticipated.