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."

Source: Investing.com