Watch Swaptions, Not the Yield Curve

Clues You Can Use

But as that most famous representative of the U.S. Cavalry, Lt. Colonel George Armstrong Custer, found out the hard way, the attitude of "so far, so good" can produce unwelcome surprises in financial markets. If the Federal Reserve continues to raise short rates at the pace implied in the fed funds futures market, to a full 4.75% by mid-2006, the very mechanics of swaps will mandate higher rates. That is, the present value of the curve will have to rise to accommodate the higher rates at the short end. The only way this will not happen is if the curve goes into a really deep inversion, of 50-75 basis points or so.

These higher swap rates will raise the cost of capital, provide yet another headwind for financial assets and increase the incentive to move back to old-fashioned fixed-rate borrowing. Already the spread between 10-year swaps and 10-year Treasuries is expanding.

Does the over-the-counter option market on interest rate swaps, or "swaptions," provide us with any clues as to where actual yield levels are headed? A swaption is the right, but not the obligation, to enter into an interest rate swap at some point in the future. A call swaption gives the buyer the right to receive the swap's fixed rate of interest and pay the floating rate of interest. This is a bullish position in bonds, because the holder will profit if interest rates fall in the future. A put swaption buyer has the right to receive the floating rate and pay the fixed rate; this is a bearish position in bonds, because the holder profits if interest rates rise in the future.

Swaption volatilities, plotted inversely, have been moving closely with swap rates since the yield curve began to flatten. The pattern has been for yields to have bottomed at high swaption volatilities and for yields to have peaked at low swaption volatilities. Swaption volatility has not fallen as rapidly as we might have expected since late October; this suggests that either yields are too high or swap rates are too high. The most probable convergence, given the widening spread between swaps and Treasuries, is a downturn in swaption volatility at higher swap rates.

Is Swaption Volatility Too High?

Source: Howard Simons

If swaption volatility rises rapidly in a rising rate environment and then turns, we can start speculating whether the Federal Reserve's rate-hike campaign is over and whether the yield curve will stop flattening. Until then, the risk is for higher rates, and that, and not any particular level of the yield curve, should be the focus of our attention.