Swaption Volatility Gap Shows Complacency on Fed Pace, UBS Says

Low volatility on options on interest-rate swaps expiring in December for one-year yields shows traders are underestimating the risk of monetary policy changes by the Federal Reserve in 2015, according to UBS AG.

Volatility on six-month options, known as swaptions, on two-year rates is about 75 percent greater than on the similar-maturity contracts on one-year swap rates. Because the options on one-year swaps give a view on yields through the end of 2015, the gap shows the volatility market is pricing in very little action from the Fed next year, followed by more forceful policy in 2016, said UBS, one of the 22 primary dealers that trade with the central bank.

“Options are like insurance against Fed action, and right now the cost for contracts that cover 2015 is very low,” Boris Rjavinski, U.S. interest-rate derivatives strategist in Stamford, Connecticut, at the bank, said in a telephone interview. “If you extend that insurance coverage into 2016, the costs jumps, which shows investors are pricing in a lot of monetary-policy uncertainty after 2015. Fundamentally, we don’t agree with this view, given our outlook that growth and inflation, as well as rates, will rise in the second half.”

U.S. yields will “jump” by the end of 2014 as the pace of the economic recovery improves, inflation accelerates and the Fed begins to signal a greater likelihood of a rate increase next year, according to UBS. The company forecasts the Treasury 10-year note yield, which was 2.51 percent today, will be 3.25 percent at year-end. The Fed will raise its target rate for overnight loans for the first time since 2006 in June 2015, according to UBS economists.

Fed Odds

Prices of federal funds futures signal a 41.8 percent probability the Fed will boost its zero-to-0.25 percent target band in June 2015, according to Bloomberg calculations.

Volatility on on six-month one-year swaptions is 27.5 basis points, or 0.275 percentage point, while that on the two-year contract is 50.3 basis points, according to data compiled by Bloomberg.

Swaptions provide a hedge on interest-rate risk. In a swap, two parties agree to exchange fixed- for variable-rate payments over a set period. Swap rates typically are higher than Treasury yields because the floating-rate payments on a swap are based on interest rates that contain credit risk, such as the London interbank offered rate, or Libor.

Fed Bank of St. Louis President James Bullard told the Council on Foreign Relations in New York yesterday a recovery in U.S. credit markets and an expanding economy make it harder to defend keeping borrowing costs low. Bullard said he favors an interest-rate increase in the first quarter of 2015.

‘Ignoring’ Risks

“The question is, why is the market ignoring the risks of 2015 Fed action, even given comments like those yesterday from Bullard?” Rjavinski said. “It’s because the ranges on rates have been so tight that it’s expensive for people to buy the six-month one-year options and own them. But at some point in time if you get enough momentum through signs of a better economy and higher inflation these prices have to normalize.”

Commerce Department figures yesterday showed the Fed’s preferred gauge of inflation, a measure tied to consumer spending, rose 1.8 percent in May from a year earlier, the closest to the central bank’s 2 percent goal since October 2012. A day earlier, a report showed the U.S. economy shrank at a 2.9 percent annualized rate in the first quarter, the worst reading since the same three months in 2009.

UBS advised clients in a note on June 25 to profit from the likely rise in volatility over the next six months by initiating a so-called straddle premium box trade structure, which involves buying and selling both six-month and two-year payer swaptions on both one-year and two-year swap rates.

A payer swaption grants the right to pay a fixed-rate on a swap contract. Payer swaptions increase in value at rates rise.

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