By Gertrude Chavez-Dreyfuss

NEW YORK (Reuters) – Ahead of the U.S. presidential election next week, investors in interest rate options are placing trades that will profit if rates stay elevated, indicating that the market anticipates a Republican party sweep.

The options market is preparing for significant post-election fluctuations in U.S. Treasury yields, the largest in over 30 years.

If Republicans secure both Congressional houses and the presidency, it could lead to higher tariffs, inflating interest rates, particularly at the longer end of the yield curve. Increased Treasury debt issuance to cover a substantial fiscal deficit is also expected to boost long-term yields.

Investors have been acquiring long-dated payer swaptions. This trade allows them to pay a fixed rate while receiving a floating rate, benefiting from consistently high interest rates.

"The options market behaves as if it's anticipating a heightened probability of a Republican sweep," said Amrut Nashikkar, managing director of fixed income strategy at Barclays. "This price action reflects expectations of rising rates and increased long-end yields."

Conversely, if Democrats win, potential tax hikes on corporations and wealthier households may hinder economic growth, leading to disinflation and possibly more aggressive Federal Reserve easing, resulting in declining interest rates, particularly at the front end of the curve.

Swaptions, a type of option based on interest rate swaps, form part of the $600 trillion over-the-counter rate derivatives market. Rate swaps are utilized by investors to hedge against interest rate risk.

Using the Secured Overnight Financing Rate (SOFR) as a reference, swaps typically reflect rate expectations.

Recent weeks have seen a rise in payer swaptions of longer maturities, spanning five to 30-year swaps, with costs of implied volatility surging as the likelihood of Republican former president Donald Trump's election success escalated on betting platforms like Polymarket. National polls present a mixed scenario, however.

On October 21, the implied volatility on one-month at-the-money options for 30-year swap rates peaked at 31.06 basis points before easing to 30.5 bps by Friday.

"The long end is notably responsive to fiscal policy due to anticipated increases in Treasury issuance, typically more pronounced at the longer end of the curve," noted Nashikkar from Barclays.

HIGHER VOLS FOR LONGER-DATED MATURITIES

Implied volatilities on one-month options for other longer-dated maturities, ranging from five to 10 years, have also escalated.

Bruno Braizinha, BofA Securities' senior rates strategist, observed, "They've risen significantly more than during previous election cycles before 2020."

With growing volatility, investors are also wagering on a noticeable increase in longer-dated rates. For example, those on 30-year swaps are expected to rise by approximately 50 bps within a month. Consequently, the cost of longer-dated trades soared to an 18-month high of 33 bps on October 22, reflecting heightened expectations that 30-year swap rates will climb 50 bps in the near term.

"The worst-case situations for bonds are the sweeps, and investors are presently hedging their portfolios accordingly," noted Braizinha from BofA.

In addition to a potential Republican sweep, investors are preparing for a notable move of 18 basis points in Treasury yields in either direction on November 6 or 7, according to the MOVE index, which is roughly 2.5 times greater than average projections for daily movements over the past month.

The MOVE index stood at 128.4 last Friday, reflecting expectations for Treasury yields across various maturities to move an average of 8 bps daily over the next 30 days.

Harley Bassman, creator of the MOVE index and managing partner at Simplify Asset Management, mentioned that option prices forecast a sharp post-election shift in Treasury yields, possibly the most significant since the Gulf War in 1991 for a known event.

Bassman pointed out that rate volatility has been significantly higher than in the stock market, attributing stock market stability to a belief that the election results are inconsequential for them.

Both Trump and Vice President Kamala Harris have indicated substantial budget deficits through increased fiscal spending, which Bassman considers favorable for the stock market and overall economy.

"Regardless of the outcome, substantial deficit spending is expected, providing a robust fiscal stimulus that will ultimately benefit the economy."