FILE PHOTO: The Federal Reserve building in Washington, D.C., U.S., September 16, 2025. REUTERS/Aaron Schwartz/File Photo

By Gertrude Chavez-Dreyfuss

NEW YORK (Reuters) -Conflicting signals from the Federal Reserve on the timing and magnitude of U.S. interest rate cuts have accelerated hedging flows into swaptions and derivatives tied to overnight rates, with investors seeking protection against heightened policy uncertainty.

Short-term volatility --specifically three-months and under -- on longer-dated swaptions such as those on 10-year and 30-year swaps has picked up following a prolonged period of compression.

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

Open interest in options linked to the Secured Overnight Financing Rate (SOFR) expiring within the next quarter has also climbed, as traders seek to navigate a policy path increasingly shaped by diverging views from Fed officials.

SOFR is the cost of overnight borrowing for short-term cash mostly secured by Treasuries as collateral, and moves in line with the Fed's policy rate.

Hedging activity, however, remained balanced, analysts said, to cover potential outcomes at the Fed's next meeting on December 9 and 10, one being another rate cut and the second a pause to await clearer economic signals.

"Open interest has picked up, volatility has picked up and the main reason is that the shutdown was resolved and a lot of data has come out and will come out," said Amrut Nashikkar, managing director and head of derivatives strategy, at Barclays in New York, referring to economic data reports from government agencies that were suspended during the shutdown.

"All that data could point in either direction: it could look weak and could cause the Fed to cut a lot more than people think. And it speaks to the uncertainty we're seeing right now."

Signals from some U.S. central bank officials, led by New York Fed President John Williams and Governor Christopher Waller, that a December rate cut may be warranted due to labor market weakness have added downward pressure on Treasury yields and reinforced dovish bets in futures markets.

Their stance, however, contrasted with several regional Fed presidents advocating a pause in easing until inflation shows a more convincing move toward the 2% target.

U.S. rate futures have now priced in an 85% chance that the Fed will cut interest rates at the December meeting, up from 50% a week ago, according to the CME's FedWatch tool.

"The Fed is a house divided still," said Kevin Flanagan, head of fixed income strategy at WisdomTree. "We have six out of the 12 regional bank presidents making a case that the Fed should pause. Three out of those six are actually voting members."

RISING SWAPTION VOLUME

U.S. swaption volume rose to $887 billion in the week ending November 7, up about 18% from levels a week ago, the latest Commodity Futures Trading Commission data showed, suggesting increased appetite for protection against sharp moves.

Implied volatility of three-month swaptions tied to 10-year swap rates peaked at a one-month high of 22.23 basis points on November 18 before easing to 20.79 bps on Wednesday.

Citi interest rate derivatives strategist Mike Chang, in a research note, pointed out that short-dated implied vol — such as three-month options on one-year swap rates — could decline further if the Fed adopts a gradual, predictable rate-cutting path over the next few months.

The implied vol of three-month swaptions on one-year swap rates, the part of the curve most sensitive to Fed policy expectations, was 22.11 bps on Wednesday, down from a two-month high of 24.52 bps on November 18.

Citi's Chang noted, however, that a looming change in Fed leadership and the potential for a more dovish policy tilt could set the stage for "outsized rate and curve moves" in the second half of next year.

Barclays' Nashikkar said trade structures in swaptions showed no clear bias on whether the Fed will cut or pause. There were receiver-based structures, or bets rates will decline, in the Fed-sensitive area of the U.S. swap curve which is the one-year maturity.

There were payer-based trades as well on 30-year maturities that reflect expectations long-term U.S. swap rates will increase, likely because the Fed may hold off cutting rates starting with the December meeting. Essentially, investors bought protection against large increases in 30-year swap rates.

Barclays also noted a surge in open interest in three-month options on SOFR expiring in March 2026.

Trades in SOFR options suggested that investors see a limited selloff, analysts said, implying rates could edge higher, while also pricing in the possibility that the Fed holds steady through the first quarter.

SOFR closely tracks the Fed's policy rate because it directly embeds market expectations of future short-term funding costs. While it is not identical to the fed funds rate, or the U.S. central bank's benchmark rate, SOFR is heavily influenced by money market conditions created by the Fed.

(Reporting by Gertrude Chavez-Dreyfuss; Editing by Alden Bentley and Chizu Nomiyama)