US hard landing bets rise in rate options market after Fed hikes

NEW YORK (Reuters) — Investors in interest rate options are paying for trades that benefit from a sharp slowdown in the U.S. economy, contrary to the upbeat outlook held by many bond market participants.

Analysts said they have seen increased demand from hedge funds in the U.S. options market for so-called “receiver swaptions,” a type of trade that pays off when interest rates fall. In general, receiver swaptions give buyers the right to enter into an interest rate swap where they receive the fixed rate and pay the floating one.

Swaptions, which are options on interest rate swaps, are one segment of the more than $600 trillion over-the-counter interest rate derivatives market. Rate swaps measure the cost of exchanging fixed-rate cash flows for floating-rate ones, or vice versa. Investors use swaps to hedge interest rate risk.

Receiver swaptions typically reflect concerns about the U.S. economic outlook, analysts said. This is the opposite of “payer swaptions” where investors buy the right to pay fixed and receive a floating rate, benefiting when rates rise as the Federal Reserve tries to slow a robust economy.

“From a macroeconomic standpoint, risks are roughly balanced between a hard landing and no landing,” said Bruno Braizinha, interest rates strategist, at BofA Securities in New York, referring to economic scenarios that reflect contraction and strong growth.

“But the options market is pricing those probabilities more skewed towards a hard landing,” he added.

Receivers were notable on shorter tenors, analysts said, such as the oneyear at-the-money options on oneyear swap rates , that part of the curve in which Fed policy is being priced.

Asset managers, on the other hand, are hedging scenarios where the economy stays resilient and interest rates stay higher for longer, Braizinha said. In this case, fund managers have been buying payer swaptions. Overall, the soft landing scenario is still the majority view, analysts said, but the hard landing case is gaining momentum.

A soft landing or no landing has been the predominant view after a slew of data that showed the U.S. economy remained stable despite being subjected to a historically aggressive Fed tightening.

Jeff Klingelhofer, co-head of investments at Thornburg Investment Management in Santa Fe, New Mexico noted that a hard landing for the U.S. economy is a reasonable expectation having gone through the Fed’s ultra-tight monetary policy.

“Just textbook economics: Higher rates mean the bar for future demand is tougher. And because a recession hasn’t come to fruition at this point, a lot of investors are quickly pivoting to, well, it’s not going to happen. I think that’s a mistake,” said Klingelhofer.

He added that while there have been pockets of strength in some economic data, the majority of these numbers suggested that a slowdown is indeed occurring.