US swaption investors pay steep price for hard-landing bets

By Gertrude Chavez-Dreyfuss

NEW YORK (Reuters) – Investors in U.S. interest rate options are paying a premium for trades that will pay off if there is a dramatic drop in interest rates, suggesting the derivatives market is pricing in a sharper slowdown than anticipated in the world’s largest economy.

This situation was a big turnaround from before the January 20 inauguration of U.S. President Donald Trump when traders in so-called “swaptions” were positioned for more tightening from the Federal Reserve due to the incoming administration’s planned tariffs and expectations that it would increase fiscal spending.

Transactional volume of swaptions, which are options on interest rate swaps, was nearly $700 billion in the week as of late February, Commodity Futures Trading Commission data showed. The underlying asset, the rate swap, measures the cost of exchanging fixed-rate cash flows for floating-rate ones, and vice versa. Swaps are used by investors to hedge interest rate risk, including exposure to Treasury securities.

Market players said there has been increased demand for “receiver swaptions,” where investors receive the fixed leg of a swap while paying the floating rate. The payoff would come when rates fall as the Fed tries to stimulate a decelerating economy by easing monetary policy.

Receivers, as they are referred to, typically reflect a dire economic outlook, and are the opposite of “payer swaptions,” a scenario in which investors buy the right to pay a fixed rate and receive a floating one. Demand for payer swaptions rises when the economy is strong and the Fed is raising rates to slow it down.

Guneet Dhingra, head of U.S. rates strategy at BNP Paribas in New York, said the options market is assigning a higher probability of a drastic fall in interest rates, although it doesn’t mean it’s going to happen.

“Those tail-risk probabilities have been elevated ever since Silicon Valley Bank went down in 2023. That risk has become more heightened in the last couple of weeks,” Dhingra noted, referring to rare market-shaking events.

Trump’s policies on tariffs along with sweeping federal government job cuts under Elon Musk’s Department of Government Efficiency (DOGE) have raised the prospect of a hard U.S. landing. Market participants feared that tariffs could raise prices for businesses and consumers, lift inflation, and undermine overall confidence, thwarting economic growth.

Trump over the weekend declined to rule out that his trade policies would lead to a recession, but clarified on Tuesday that he does not see one happening.