In the world of fixed income, the recent dynamics in US 10-year Treasury notes have captured the attention of investors. The options market has undergone a significant shift, with skew levels now heavily favoring puts—a clear indication that the market is bracing for further downside risk in bonds. This change highlights a shift in sentiment, driven by multiple key factors, including payroll data, the upcoming US elections, and future Federal Reserve actions.

Here’s a closer look at what’s going on:

Extreme Skew in the Options Market

Currently, the 1-month options skew on US 10-year Treasury (TY) notes is at extreme levels, signaling a strong preference for put options. Compared to the skew levels seen at the end of July, the market has essentially flipped. Back then, the options skew leaned toward the market speculating about how many interest rate cuts the Federal Reserve might make. Now, the focus has shifted completely—investors are asking how few cuts, if any, will happen in the near term.

This is significant because it reflects growing concerns over a possible further selloff in the bond market. Investors are now willing to pay a premium to hedge against this scenario, signaling an increasingly cautious sentiment. Bloomberg notes that the rising skew indicates that participants are hedging more aggressively for a potential steep decline in bond prices.

Why Is This Happening?

Several key factors are contributing to the dramatic shift in options skew:

1. Rising Inflation Premiums: Inflation remains a persistent issue. The rise in the inflation premium is one of the key drivers behind the bond market’s current pricing. Despite efforts from the Fed to cool inflation with aggressive rate hikes, inflationary pressures have not entirely subsided, keeping yields elevated.
2. Election Uncertainty and Fiscal Risk: The upcoming US elections add a layer of uncertainty to the bond market. Election results could significantly impact fiscal policy, which, in turn, would influence the trajectory of inflation and interest rates. Investors are factoring in potential fiscal changes that may arise from shifts in political leadership, particularly concerning spending and budget priorities.
3. Fed Reaction Function: The Federal Reserve’s response to evolving economic conditions remains a central concern for bond investors. After a period of aggressive tightening, the market is now focused on how the Fed will navigate an economic landscape that includes persistent inflation, election risks, and the possibility of a slowdown. With payroll data and other economic indicators suggesting resilience in the labor market, the Fed may hold off on cuts, or worse, maintain higher rates for longer. This uncertainty around the Fed’s reaction function is a key reason behind the hedging activity in the options market.

A Bond Market at a Crossroads

The bond market is at a crucial turning point. The MOVE index, which tracks bond market volatility, is at similar levels to those seen in late July. However, the market’s focus has completely shifted since then. Back in July, investors were concerned with how many rate cuts might come as the economy showed signs of slowing. Today, the narrative has flipped, with investors more worried about the potential for stubbornly high rates and a lack of cuts as the Fed navigates inflation risks and economic uncertainty.

This shift has prompted a dramatic rise in put option buying, as bondholders seek protection against further price declines. Given the rising inflation premium, the possibility of fiscal tightening (or loosening) post-election, and the unpredictability of the Fed’s policy response, it’s no surprise that market participants are willing to pay up for downside protection.

What Lies Ahead?

As the market digests payroll data, monitors Fed signals, and assesses election risks, investors are bracing for more turbulence in the bond market. The extreme levels of skew in options pricing suggest that market participants are expecting potential volatility, and are preparing for the possibility of further bond selloffs.

For now, all eyes remain on how these key factors—economic data, fiscal policy, and central bank moves—will play out. Until there is more clarity on these fronts, investors will likely continue to hedge against downside risks in the US 10-year notes, keeping put options in high demand.

The shift in options skew on US 10-year notes is a reflection of broader market anxieties, driven by inflation, election uncertainty, and Fed policy. With investors now paying a premium to hedge against a larger bond market selloff, it’s clear that caution is the prevailing sentiment. As we head toward the elections and continue to assess the economic landscape, volatility is likely to persist, keeping the focus on how the Fed will respond to changing conditions.