Derivatives signal investors becoming too complacent over rates

A month is a long time in financial markets. As Big Ben tolled on the start of 2023 we knew we were facing a year of higher interest rates than we have known for nearly two decades.

However, at that time the derivatives market was telling us that the consensus might be underestimating how fast those interest rates would start to fall. Since then we have had a meeting of the Federal Reserve’s Monetary Policy Committee and a blizzard of incoming data. The data robustly shows inflation falling, including in sticky areas such as goods. Markets have risen sharply. Yet it also shows a more resilient economy than many could have hoped for, perhaps a little too good for those hoping for rapidly-falling rates.

This was seen most clearly in the data last Friday showing the US added a full 517,000 jobs in December, more than double the consensus forecast. Such data points unnerve the market which knows it risk running ahead of itself and overestimating how fast inflation and rates will fall.

When analysing critical questions such as; ‘when will the Federal Reserve pivot?’ we look at a specific portion of the derivatives market called swaptions. The swaptions market enables investors to protect themselves against a change in interest rates over future time periods. This involves paying the current interest rate and receiving a fixed rate over future term or vice versa.

The important signal offered by this market is found within analysing whether investors are paying a higher premium to insure against a surprise move up or down in interest rates. We can examine the curve of how investors over different time periods are pricing this risk out from three months to one year.

This analysis shows that in December the derivatives market was more aggressively pricing in a risk that rates were lower than anticipated. However, since then this has flipped with a ‘right-tail event (namely an unexpectedly higher interest rate) now considered a more likely scenario.

Source: Bloomberg at 03.02.23 

Importantly, this signal could be clearly seen before the shock jobs report last Friday demonstrating the importance of multi-asset investors keeping a weather eye on developments in the derivatives market.

Derivative signals are complex and require expertise to interpret. Yet they are real-time and mathematically robust.

To explore how you can build derivative strategies into your portfolio contact the Atlantic House Investments distribution team.