With the U.S. presidential election approaching next week, interest rate options investors are initiating trades that will yield profits if rates stay high, indicating that the market anticipates a Republican party victory.
The options market is also preparing for the most significant post-election fluctuations in U.S. Treasury yields observed in over 30 years.
Should Republicans gain control of both the House and Senate along with the presidency, it is expected to result in increased tariffs, and therefore higher interest rates, particularly at the longer end of the yield curve, driven by inflation. A surge in U.S. Treasury debt to cover a substantial fiscal deficit will also push up yields on the longer end.
Investors are acquiring long-dated payer swaptions, a trade allowing them to secure a fixed payment while receiving a floating one, thus profiting when interest rates are sustained at elevated levels.
“The options market is acting as if it expects a greater likelihood of a Republican sweep,” remarked Amrut Nashikkar, managing director of fixed income strategy at Barclays. “This market behavior aligns with expectations: rates climbing higher and long-term rates rising.”
Conversely, if Democrats win, it could lead to increased taxation on corporations and high-income households, potentially dampening economic growth. A phase of disinflation seems likely, which could prompt more aggressive easing from the Federal Reserve. In such a scenario, interest rates are expected to drop, particularly at the front end of the curve.
Swaptions, or options on interest rate swaps, represent one segment of the over $600 trillion over-the-counter derivatives market. Rate swaps allow the exchange of fixed-rate cash flows for floating-rate ones and vice versa, providing a hedge against interest rate risk for investors.
Using the Secured Overnight Financing rate (SOFR) as the benchmark, swaps typically mirror rate expectations.
Payer swaptions were prominently noted in longer maturities from five to 30 years, where the cost of implied volatility—a measure for pricing these options—spiked a few weeks back as online betting odds on Republican former president Donald Trump’s election chances rose on platforms like Polymarket. However, national polls indicate uncertainty.
The implied volatility on one-month at-the-money options for 30-year swap rates reached its peak for the year at 31.06 basis points (bps) on Oct. 21 but declined slightly to 30.5 bps the following Friday.
“The long end is typically very sensitive to fiscal policy due to anticipated increases in Treasury issuance, which tends to be higher on the longer end of the curve,” stated Nashikkar from Barclays.
“The increases observed are substantially higher than what we recorded during election cycles prior to 2020,” explained Bruno Braizinha, senior rates strategist at BofA Securities.
As volatility rises, investors are anticipating a shift upwards in longer-dated rates, including expectations that 30-year swap rates may rise about 50 bps within a month.
The cost of longer-dated trades peaked at an 18-month high on Oct. 22 at 33 bps, indicating a growing expectation that 30-year swap rates could elevate by 50 bps in a month, likely due to corresponding increases in 30-year Treasury yields.
“The worst-case scenarios for bonds involve the sweeps, and investors are proactively hedging to protect their portfolios against that,” commented Braizinha from BofA.
In addition to anticipating a Republican sweep, investors are also preparing for a significant shift of 18 basis points in Treasury yields in either direction around Nov. 6 or 7, based on the MOVE index. This figure is roughly 2.5 times the average daily movements projected by the current index over the month.
The MOVE index, which serves as a benchmark for rate volatility, stood at 128.4 last Friday, indicating expectations that Treasury yields across various maturities will fluctuate by an average of 8 bps daily in either direction over the upcoming 30 days.
Harley Bassman, creator of the MOVE index and managing partner at Simplify Asset Management, stated that option prices foresee a pronounced movement in Treasury yields post-election, possibly the largest such shift since the 1991 Gulf War tied to a known event.
He remarked that rate volatility has significantly outstripped that in the stock market, which Bassman believes has grown more complacent regarding the election.
U.S. stock volatility remains comparatively lower as Bassman perceives financial markets as indifferent to the election outcome. Both Trump and Vice President Kamala Harris have indicated plans for substantial increases in the budget deficit via elevated fiscal expenditures, which he suggested would be beneficial for both the stock market and the economy.
“Regardless of the election outcome, substantial deficit spending will ensue, generating significant fiscal momentum; ultimately acting as a tailwind for the economy.”
