Demand for options that protect against higher long-term interest rates is the weakest since October, signaling to some analysts that yields are poised to rise from close to the lowest in more than three years.

An indicator known as the swaption skew, which traders watch for a hint of where yields are headed, hasn't been as biased toward lower rates since October. Ten-year Treasury yields reversed course that month, rising almost 0.5 percentage point within about three weeks and halting a rally that followed the Federal Reserve's September decision to forgo lifting its target from near zero. Movements in swap rates tend to mirror the direction of Treasury yields.

“The market is not pricing in higher rates right now, so the cost of insuring against that in options is low,” indicated by the skew, said Scott Buchta, head of fixed-income strategy at Brean Capital in New York. “I'd be counterintuitive here—and be totally hedging for higher rates. The market is so dislocated from the Fed now with their forward rate projections.”

The skew for three-month options, which shows whether traders are more eager to lock in the right to pay or receive fixed rates on 10-year interest-rate swaps, shows nearly equal demand for one contract over the other, data compiled by Bloomberg show. In mid-December, before the Fed hiked rates, there was a premium for options that profit if rates rise.

Momentum Shift in Interest Rate Expectations

With global equities and oil tumbling to start the year and concern building over European banks, traders have practically written off another quarter-point increase by the Fed at least until next year. The benchmark 10-year Treasury yield touched 1.53 percent on Feb. 11, its lowest since August 2012, before climbing to 1.8 percent Wednesday. In December, Fed officials projected four rate increases in 2016.

While acknowledging that global financial conditions have worsened since December, Fed Chair Janet Yellen assured U.S. lawmakers last week in congressional testimony that the economy is strong enough to weather a gradual tightening of policy. The Fed releases the minutes of its January policy meeting, when it kept borrowing costs unchanged, on Wednesday.

Derivatives Offer a Clue

In an interest-rate swap, two parties agree to exchange fixed for floating payments over a set period of time, with the floating rate typically based on changes in the London interbank offered rate, or Libor. Swaptions are options on those deals.

Derivative traders see the Fed's effective rate rising to 0.66 percent in two years, from the current 0.38 percent level, meaning they're pricing in about one quarter-point rate increase in that period.

Traders may be reluctant to abandon bets on lower note yields. Even as the nation's jobless rate has declined to an eight-year low, there are signs that economic growth is cooling. Service industries expanded in January at the slowest pace in nearly two years.

“People are more afraid of a sustained move lower in yields,” said Gennadiy Goldberg, an interest-rate strategist in New York at TD Securities (USA) LLC, one of the 22 primary dealers that trade with the Fed. “The question is, is it all over? I just don't think enough people are ready to make that call yet—that this is the end.”

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Risk of Treasuries Selloff

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