Garrett DeSimone, PhD

The “Trump Tariff Wars 2.0” have given rise to increased market volatility and broad fears regarding stagflation. This has placed the Fed in a precarious position, as it must balance the risks between declining future growth and reflation. In this environment, any information regarding interest rate risk becomes increasingly valuable.

We often utilize Implied Volatility (IV) skewness, at OptionMetrics, as a measure of upside and downside sentiment in markets. IV skewness is extracted from the volatility surface, calculated as the 25 Delta put IV – 25 delta call IV at a fixed 30-day horizon. A positive skew (which is typical of index options) is indicative of higher premiums for downside hedging and a higher aversion to crash risk. This application can be carried over to the market for 10-year treasury options.

Options on CME 10-year Treasury futures deliver a future, which is based on price. An increase in the price of the future corresponds to falling yields. Therefore, a negative skew is indicative of relatively higher call premiums, and hedging concerns regarding downward yield pressures. Chart 1 plots the Normalized IV skew on 10-year futures.

As of Q1 2025, the skew has dropped precipitously, coinciding with the downward growth forecasts. Although, this would not be the first time a negative skew has appeared during this hiking cycle; options have priced in upward sentiment several other times since 2022. Notably, this includes the failure of Silicon Valley Bank in 2023 and yen-carry scare of August 2024.

However, what differs in the current environment is the presence of an upward sloping yield curve. Chart 2 plots 10-year minus 2-year spread data from FRED.

In the current environment, The Fed is easing, but markets are uncertain about the long-term trajectory of inflation and economic growth. Given this part of the economic cycle and a steepening yield regime, a negative skew points to two likely outcomes.

1) Continued positive returns to holding bonds.

2) An increase in the number of anticipated rate cuts.

The current market environment presents a telling picture through the lens of treasury option pricing. The sharp decline in IV skew for 10-year treasury futures in Q1 2025 reveals strong market sentiment favoring lower future yields, occurring against the backdrop of Trump’s renewed tariff policies and growing stagflation concerns. Unlike previous instances of negative skew during this hiking cycle (such as the SVB failure in 2023 and the yen-carry scare of 2024), today’s negative skew coincides with a sustained steepening, upward sloping yield curve. This distinctive combination suggests markets are pricing in significant downside yield pressure despite the Fed’s delicate balancing act between growth concerns and reflation risks. Put simply, investors are preparing for sudden rate drops while still expecting a steeper yield curve—an unusual market signal.