NEW YORK (Reuters) -Investors in U.S. interest rate options are paying a premium for trades that will pay off if there is a dramatic drop in interest rates, suggesting the derivatives market is pricing in a sharper slowdown than anticipated in the world's largest economy.

This situation was a big turnaround from before the January 20 inauguration of U.S. President Donald Trump when traders in so-called "swaptions" were positioned for more tightening from the Federal Reserve due to the incoming administration's planned tariffs and expectations that it would increase fiscal spending.

Transactional volume of swaptions, which are options on interest rate swaps, was nearly $700 billion in the week as of late February, Commodity Futures Trading Commission data showed. The underlying asset, the rate swap, measures the cost of exchanging fixed-rate cash flows for floating-rate ones, and vice versa. Swaps are used by investors to hedge interest rate risk, including exposure to Treasury securities.

Market players said there has been increased demand for "receiver swaptions," where investors receive the fixed leg of a swap while paying the floating rate. The payoff would come when rates fall as the Fed tries to stimulate a decelerating economy by easing monetary policy.

Receivers, as they are referred to, typically reflect a dire economic outlook, and are the opposite of "payer swaptions," a scenario in which investors buy the right to pay a fixed rate and receive a floating one. Demand for payer swaptions rises when the economy is strong and the Fed is raising rates to slow it down.

Guneet Dhingra, head of U.S. rates strategy at BNP Paribas in New York, said the options market is assigning a higher probability of a drastic fall in interest rates, although it doesn't mean it's going to happen.

"Those tail-risk probabilities have been elevated ever since Silicon Valley Bank went down in 2023. That risk has become more heightened in the last couple of weeks," Dhingra noted, referring to rare market-shaking events.

Trump's policies on tariffs along with sweeping federal government job cuts under Elon Musk's Department of Government Efficiency (DOGE) have raised the prospect of a hard U.S. landing. Market participants feared that tariffs could raise prices for businesses and consumers, lift inflation, and undermine overall confidence, thwarting economic growth.

Trump over the weekend declined to rule out that his trade policies would lead to a recession, but clarified on Tuesday that he does not see one happening.

Treasury Secretary Scott Bessent, on the other hand, said last week that the U.S. economy may slow as it transitions away from public spending towards more private spending, calling it a "detox period."

EXTREME SCENARIO

Analysts said the price for protecting against an extreme scenario such as a drop of 100 basis points (bp) in swap rates in the near term has increased in the swaptions market.

That shift suggests market players are preparing for the worst. A sharp fall in swap rates can only be triggered by a huge drop in the federal funds rate, currently at 4.33%, when the U.S. central bank undertakes sharp policy easing.

The cost of protecting against a 100-bp plunge in one-year swap rates at the end of six months, for instance, had surged to 40.24 bps on Thursday, up from 32.30 bps on February 20, when it fell to its lowest reading since mid-December. The one-year swap rate was 4.036% on Thursday.

While no one is forecasting a 100-bp near-term decline in one-year swap rates or the fed funds rate, BNP's Dinghra noted that the options market always takes into account the worst outcomes.

"The options market is showing signs of an economic slowdown, but not a recession that causes the Fed to cut by hundreds of basis points," said Amrut Nashikkar, managing director of fixed income strategy at Barclays in New York.

But he pointed out that there are indeed investors positioned for a tumble of 100 to 150 bps in one-year swap rates over a one-year period.

As the cost of near-term protection against a big drop in rates grew, implied volatility, a key input in option prices, also rose. The higher the volatility, the greater the uncertainty over a given period.

The price of implied volatility of one-month options on one-year swap rates had risen to a four-month high of 23.8 bps on Monday, and was last at 20.36 bps.

The increase in implied volatility is not surprising given exogenous risks on tariffs, including persistent geopolitical headwinds, said Srini Ramaswamy, managing director and head of derivatives strategy at J.P. Morgan in San Francisco.

"Markets and the macroeconomy find themselves in a superposition between tariff-on and tariff-off states, which is creating considerable uncertainty and likely contributing to rising risk premium," resulting in intraday volatility creeping to its highest level in the last six months, Ramaswamy said.