U.S. Rates Volatility Gears Up for Ageing Business Cycle to Turn

(Bloomberg) -- A surge in U.S. rates volatility may have legs as traders stare at the prospect of a full easing cycle by the Federal Reserve.

With the life expectancy of the ageing business cycle uncertain, bets on short-term volatility in the rates swaps market would benefit if recessionary forces take hold to drive the Fed on a path to steep rate cuts. However, if policy makers can convince the market to remain patient after one cut and the macro-economic backdrop supports that case, then strategies betting on a pull back in volatility would perform well.

• The elevated policy uncertainty is leading to markets pricing in four Fed rate cuts over the next year; short-expiry, short-tenor (upper-left on the swaption surface) volatility has been extremely well-bid, with 3m2y up over 40 basis points (annual) from last month
• Fading this via delta-hedged straddles is on the radar given short rates vol has remained an attractive yield enhancement strategy (being monetized and compounded by systematic short-gamma programs) and the moves having potentially being exacerbated by dealer positioning
• However, the short vol play has been reliant upon central bank predictability and stable economic data, which have both gone into reverse of late and are major risks to short gamma strategies
• Vol may reset lower if Fed convinces the market that any “insurance” cut will be followed by a long pause and the expansion extending; a shallow rate-cut cycle with soft landing will benefit receiver spreads against payer structures at the front end
• That won’t preclude a subsequent vol spike as any pause by the Fed may lead to a further build up of excesses, paving the way for a deeper downturn and policy rates going all the way back to the zero lower bound
• The recent inversion of the 3m/10y Treasury yield curve for the first time since 2007 is suggestive of increased recession risk in 2020, given it has been historically a powerful indicator, though very low yields and term premium reduce its reliability
• NOTE: USD Rates Volatility Is Waiting for the Business Cycle to Turn
• NOTE: Tanvir Sandhu is a global interest-rate and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice

To contact the reporter on this story: Tanvir Sandhu in London at tsandhu17@bloomberg.net

To contact the editors responsible for this story: Ven Ram at vram1@bloomberg.net, Neil Chatterjee, Scott Hamilton

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