Interest Rate Market Monitor 2nd Quarter 2013
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Transcript of Interest Rate Market Monitor 2nd Quarter 2013
INTEREST RATES
Interest Rate Market Monitor 2nd Quarter 2013
JULY 8, 2013
John W. Labuszewski Michael Kamradt
Managing Director Executive Director
Research & Product Development
312-466-7469
Interest Rate Products
312-466-7473
1 | Interest Rate Market Monitor 2nd Quarter 2013 | July 8, 2013 | © CME GROUP
Fixed income market participants may trade based
upon performance expectations couched along
several dimensions including outright yield
movements, changes in the shape of the yield curve,
dynamic credit risks as well as volatility
considerations.
CME Group offers interest rate futures and options
that allow one to engage in trading activities driven
by any of these significant factors. Our offerings
includes Eurodollar, Treasury, Fed Funds, Swap and
other interest rate products covering the entire
spectrum of the yield curve, representing both public
and private credit risks. Further, our offerings
include options on the most popular of our interest
rate futures contracts.
This document represents a review of these factors
as they played out in the most recently completed
calendar quarter and the impact they have exerted
on CME Group interest rate products. We begin with
a review of fundamental economic conditions as a
backdrop of how this impacts upon outright yield
movements, the shape of the curve and credit
considerations.
Growth and Employment
Taking our cue from the Federal Reserve’s most
recent observations on the economy, we find “that
economic activity has been expanding at a moderate
pace. Labor market conditions have shown further
improvement in recent months, on balance, but the
unemployment rate remains elevated.” 1
1st quarter 2013 growth was most recently reported
at +1.8% - although that figure has been steadily
revised downward from its advance estimate of
2.5% and the preliminary estimate of 2.4%.
Unemployment has been generally declining in 2013
although we took a step back as the May 2013
figure up-ticked to 7.6% from April’s 7.5%. Labor
force participation remains very low at only 63.4%
in May although this represents an improvement
from the trough of 63.3% recorded in March.
1 Federal Reserve Press Release dated June 19, 2013.
The Fed further observes that “household spending
and business fixed investment advanced.” 2 These
developments are reflected in retail sales figures
which advanced to $181.7 billion in May and up
2.9% on a year-on-year basis from the previous
May.
The Industrial Production Index has advanced
1.61% over the same year-on-year period.
However, it has down-ticked a few notches from a
recent peak of 99.0584 in March to May’s 98.6709.
This is further reflected in a downtick in capacity
utilization from a recent peak of 78.1% in March to
77.6% in May.
2 Ibid.
4%
5%
6%
7%
8%
9%
10%
11%
-10%
-8%
-6%
-4%
-2%
0%
2%
4%
6%
Q1 0
5
Q3 0
5
Q1 0
6
Q3 0
6
Q1 0
7
Q3 0
7
Q1 0
8
Q3 0
8
Q1 0
9
Q3 0
9
Q1 1
0
Q3 1
0
Q1 1
1
Q3 1
1
Q1 1
2
Q3 1
2
Q1 1
3
Unem
plo
ym
ent
Rate
Qtr
ly C
hange in G
DP
Growth and Employment
Real GDP (SA) Unemployment Rate
Source: Bureau of Economic Analysis (BEA)
& Bureau of Labor Statistics (BLS)
63%
64%
65%
66%
67%
4%
5%
6%
7%
8%
9%
10%
11%
Jan-0
2
Jan-0
3
Jan-0
4
Jan-0
5
Jan-0
6
Jan-0
7
Jan-0
8
Jan-0
9
Jan-1
0
Jan-1
1
Jan-1
2
Jan-1
3
Labor
Forc
e P
art
icip
ation
Unem
plo
ym
ent
Rate
Employment Statistics
Unemployment Rate Labor Force Partcipation
Source: Bureau of Labor Statistics (BLS)
2 | Interest Rate Market Monitor 2nd Quarter 2013 | July 8, 2013 | © CME GROUP
While industrial sector activity remains below the
pre-subprime crisis peak, corporate profitability has
soared to new all-time highs by a wide margin. 1st
quarter profitability increased some 4.7% although
this represents a slow-down from the previous 4
quarters.
The Fed goes on to suggest that the “housing sector
has strengthened further.” 3 This is reinforced by an
11.58% advance in the S&P/Case-Shiller 10-City
Composite Housing Index in April on a year-on-year
basis from the previous April. This represents the
strongest performance observed in this Index since
early 2006 and prior to the onset of the subprime
mortgage crisis which saw residential home values
plummet beginning in mid-2006.
3 Ibid.
Inflation
The FOMC’s statement goes on to say “[p]artly
reflecting transitory influences, inflation has been
running below the Committee’s longer-run objective,
but longer-term inflation expectations have
remained stable … The Committee also anticipates
that inflation over the medium term likely will run at
or below its 2 percent objective.” 4
The Consumer Price Index (CPI) was reported to
have advanced 1.4% on a year-on-year basis in May
2013. Core inflation, excluding volatile food and
energy prices, rose 1.7% over the same period.
Thus, by any measure, inflation is relatively muted.
4 Ibid.
1.20
1.25
1.30
1.35
1.40
1.45
1.50
$150
$155
$160
$165
$170
$175
$180
$185Ja
n-0
7
Jul-
07
Jan-0
8
Jul-
08
Jan-0
9
Jul-
09
Jan-1
0
Jul-
10
Jan-1
1
Jul-
11
Jan-1
2
Jul-
12
Jan-1
3
Invento
ry:S
ale
s R
atio
Reta
il S
ale
s (
Bil $
)
Retail Sector Activity
Real Retail Sales & Food Services SATotal Business Inventory:Sales Ratio
Source: U.S. Census Bureau
66%
68%
70%
72%
74%
76%
78%
80%
82%
80
85
90
95
100
105
Jan-0
7
Jul-
07
Jan-0
8
Jul-
08
Jan-0
9
Jul-
09
Jan-1
0
Jul-
10
Jan-1
1
Jul-
11
Jan-1
2
Jul-
12
Jan-1
3
Capacity U
tilization
Industr
ial Pro
duction I
ndex
Industrial Sector Activity
Index of Industrial Production Capacity Utilization
Source: St. Louis Federal Reserve FRED Database
$0
$200
$400
$600
$800
$1,000
$1,200
$1,400
$1,600
$1,800
$2,000
-60%
-40%
-20%
0%
20%
40%
60%
80%
100%
120%
Q1 0
4
Q4 0
4
Q3 0
5
Q2 0
6
Q1 0
7
Q4 0
7
Q3 0
8
Q2 0
9
Q1 1
0
Q4 1
0
Q3 1
1
Q2 1
2
Q1 1
3
Pre
-Tax P
rofits
(Billions)
Annualized C
hange
U.S. Corporate Profitability
Annual Change Corporate Profits (Bil)
Source: Department of Commerce
80
120
160
200
240
280
320
Jan-0
0
Nov-0
0
Sep-0
1
Jul-
02
May-0
3
Mar-
04
Jan-0
5
Nov-0
5
Sep-0
6
Jul-
07
May-0
8
Mar-
09
Jan-1
0
Nov-1
0
Sep-1
1
Jul-
12
May-1
3
S&P/Case-Shiller Housing Indexes
Los Angeles San Diego San FranciscoDenver Washington DC MiamiChicago Boston Las VegasNew York Comp-10
Source: Standard & Poor's
3 | Interest Rate Market Monitor 2nd Quarter 2013 | July 8, 2013 | © CME GROUP
Monetary Policy
To the extent that “[t]he Committee expects that,
with appropriate policy accommodation, economic
growth will proceed at a moderate pace and the
unemployment rate will gradually decline toward
levels the Committee judges consistent with its dual
mandate,” monetary policy remains virtually
unchanged. 5
“In particular, the Committee decided to keep the
target range for the federal funds rate at 0 to ¼
percent and currently anticipates that this
exceptionally low range … will be appropriate at
least as long as the unemployment rate remains
above 6-1/2 percent, inflation between one and two
years ahead is projected to be no more than a half
percentage point above the Committee’s 2 percent
longer-run goal, and longer-term inflation
expectations continue to be well anchored.” 6
While the Committee restated its determination to
stay this course, it significantly did not mention a
period of time over which it expects to maintain Fed
Funds at its current levels.
While Fed Funds has served as the primary tool of
monetary policy, the FOMC’s asset repurchase
programs (aka Quantitative Easing or “QE”) have
exerted a significant dampening effect on longer-
term yields. Many analysts have suggested that the
5 Ibid. 6 Ibid.
Fed may be preparing to discontinue or at least
reduce the scale of this stimulus.
This suggestion is based upon indications of Fed
flexibility regarding these policies as Fed Chairman
Bernanke has suggested that the Fed “is prepared to
increase or reduce the pace of its asset purchases to
ensure that the stance of monetary policy remains
appropriate as the outlook for the labor market or
inflation changes.” 7 As a result, we have seen 10-
year Treasury rates rally from 1.85% at the
conclusion of the 1st quarter to just over 2.5% as of
this writing.
Still, the Committee’s most recent statement
suggests that will “continue purchasing additional
agency mortgage-backed securities at a pace of $40
billion per month and longer-term Treasury
securities at a pace of $45 billion per month …
maintaining its existing policy of reinvesting principal
payments from its holdings … and rolling over
maturity Treasury securities at auction.” 8
Fiscal Policy
The fiscal stimulus implicit in the 2009, 2010 and
2011 Federal budget deficits of $1.4 trillion, $1.3
trillion and another $1.3 trillion, respectively, has
shrunk to $1.1 trillion in 2012. Further restraint in
7 Testimony of Chairman Ben S. Bernanke on the
Economic Outlook before the Joint Economic
Committee, U.S. Congress, Washington D.C. (May 22,
2013). 8 Op cit, Federal Reserve Press Release dated June 19,
2013.
-3%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
Jan-0
4
Sep-0
4
May-0
5
Jan-0
6
Sep-0
6
May-0
7
Jan-0
8
Sep-0
8
May-0
9
Jan-1
0
Sep-1
0
May-1
1
Jan-1
2
Sep-1
2
May-1
3
Year-
on-Y
ear
Change
Consumer Price Index (CPI)
CPI - All Urban Consumers SA CPI ex-Food & Energy SA
Source: Bureau of Labor Statistics (BLS)
0%
1%
2%
3%
4%
5%
6%
7%
Jan-0
1
Jan-0
2
Jan-0
3
Jan-0
4
Jan-0
5
Jan-0
6
Jan-0
7
Jan-0
8
Jan-0
9
Jan-1
0
Jan-1
1
Jan-1
2
Jan-1
3
Benchmark U.S. Rates
Target Fed Funds 2-Yr Treasury5-Yr Treasury 10-Yr Treasury30-Yr Treasury
4 | Interest Rate Market Monitor 2nd Quarter 2013 | July 8, 2013 | © CME GROUP
early 2013 is also in evidence. As such, the FOMC
concedes that “fiscal policy is restraining economic
growth.” 9
Fed Chairman Bernanke elaborates on this point,
suggesting that “the expiration of the payroll tax
cut, the enactment of tax increases, the effects of
the budget caps on discretionary spending, the
onset of the sequestration, and the declines in
defense spending for overseas military operations
are expected, collectively, to exert a substantial
drag on the economy … [that is estimated to] slow
the pace of real GDP growth by about 1-1/2
percentage points during 2013, relative to what it
would have been otherwise.”
But the Congressional Budget Office (CBO) has
indicated that “under current policies, the federal
deficit and debt as a percentage of GDP will begin
rising again in the latter part of this decade and
move sharply upward thereafter, in large part
reflecting the aging of our society and projected
increases in health-care costs, along with mounting
debt service payments.” 10
Still, we note that the CBO’s projections regarding
fiscal policy, as of May 2013, are much rosier than
they were a scant two years ago in 2011. The
current CBO baseline forecast has the ratio of
Federal debt to GDP rising from 2012’s 71.9% to
only 73.6% by 2023. Their most pessimistic
9 Ibid. 10 Op. cit., Testimony of Chairman Ben S. Bernanke (May
22, 2013).
alternative forecast released in 2011 had that ratio
climbing to 109.0% by 2023. While the impact of
restrained fiscal policies may represent a short-term
drag on GDP, the longer-term benefits seem
obvious.
Current & Capital Account Flows
The 1st quarter 2013 current account deficit
increased to $106.1 billion or 2.7% of GDP. This
represents a slight setback from the revised 4th
quarter report of a $102.3 billion deficit, or 2.6% of
GDP. While the current figure was a downtick, the
situation nonetheless is much improved from the
previous year or certainly from the pre-subprime
crisis period.
Another interesting source of flow of funds data may
be found in the U.S. Treasury Department’s
Treasury International Capital (or “TIC”) database.
This database tracks flows into and out of the U.S.
The data is broken into foreign stocks, foreign
bonds, U.S. stocks, U.S. corporate bonds, U.S.
government agencies and U.S. Treasuries.
U.S. vs. overseas capital flows have generally been
characterized over the past decade by substantial
influx of funds into U.S. Treasuries. This
phenomenon peaked in 2010 as overseas investors
purchased some $704 billion in U.S. Treasuries on a
net basis. The figure tailed off to $433 and $417
billion in 2010 and 2011, respectively, but that still
represents sizable values.
0%
20%
40%
60%
80%
100%
120%
1940
1950
1960
1970
1980
1990
2000
2010
2012
Est
14
Est
16
Est
18
Est
20
Est
22
US Gross Public Debt as % of GDP
Debt as % GDP (NSA) CBO Forecast May-13
CBO Alt Forecast 2011
Source: Congressional Budget Office
-$250
-$200
-$150
-$100
-$50
$0
Q1 0
4
Q3 0
4
Q1 0
5
Q3 0
5
Q1 0
6
Q3 0
6
Q1 0
7
Q3 0
7
Q1 0
8
Q3 0
8
Q1 0
9
Q3 0
9
Q1 1
0
Q3 1
0
Q1 1
1
Q3 1
1
Q1 1
2
Q3 1
2
Q1 1
3
U.S. Current Account Deficit(Billions USD)
Source: Bureau of Economic Analysis (BEA)
5 | Interest Rate Market Monitor 2nd Quarter 2013 | July 8, 2013 | © CME GROUP
But during the first four months of 2013, foreign
investors sold some $14 billion of Treasuries on a
net basis. Some $37 billion in capital has flowed out
of the U.S. on a net basis through April 2013.
While the U.S. current account deficit remains
substantial, it appears that foreign investors are
become reticent to increase U.S. capital market
holdings. Certainly this is motivated by the
prospects of rising rates and declining Treasury
values in the face of at least modest economic
recovery.
Outright Yield Movements
Interest rates have started to come off of the
extreme lows that have been observed in recent
months and years. Still, we remain at reasonably
low levels. Should economic recovery continue and
if the Fed should, as a result, discontinue its
stimulus in the form of asset repurchase programs,
it is certainly conceivable that further rate advances
may be forthcoming. This implies declining fixed
income asset values and represents a further source
of global risk as explained in more detail below.
We might measure the prospective risk of rising
rates by resorting to an analysis known as
“breakeven (B/E) rate analysis.” This technique
addresses the questions – how much do rates need
to advance, measured in basis points (bps), before
investors suffers a loss by holding a particular
security or portfolio?
In order to address this question in a current
context, we examined the characteristics of various
indexes as published by Barclays Capital including
the U.S. Treasury Index (inclusive of all maturities);
the Intermediate Treasury Index (1-10 year
maturities); the Long Treasury Index (10+ year
maturities); and the Aggregate Index (includes
mortgages and corporates).
This analysis is generally conducted over a twelve-
month time horizon and takes into account any
income generated by holding the security. One may
estimate the rate advance required to offset income
over a 12-month period by simply dividing the yield
on the index by its duration.
Breakeven Rate Analysis
(6/28/13)
Barcap
Index
2013
YTD
Return
Duration
(Years) Yield
B/E
Rate
Advance
U.S.
Treasury -2.11% 5.2 1.23% 24 bps
Intermediate
Treasury -1.28% 3.7 0.96% 26 bps
Long
Treasury -7.83% 16.3 3.30% 20 bps
Aggregate -2.44% 5.2 2.35% 45 bps
E.g., if rates advance 24 basis points (bps) or 0.24%
on all securities in the U.S. Treasury Index over the
course of the next 12 months, the returns
associated with the index will equate to zero, or the
breakeven point. This is calculated as the yield in
basis points divided by duration or 24 bps (=123 bps
÷ 5.2 years).
E.g., the breakeven rate advance for intermediate
Treasuries is 26 bps (=96 bps ÷ 3.7 years).
-$800
-$300
$200
$700
$1,200
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Thru
4/1
3
Net US/Foreign Capital Flows (Billions USD)
US Treasuries US Gov't Agencies US Corporates
US Stocks Foreign Bonds Foreign Stocks
Source: U.S. Treasury TIC Database
0
50
100
150
200
250
U.S. Treas Inter Treas Long Treas Aggregate
Breakeven Rate Analysis(Basis Points)
Dec-99 Dec-07 Dec-12 Jun-13
Source: Bloomberg
6 | Interest Rate Market Monitor 2nd Quarter 2013 | July 8, 2013 | © CME GROUP
E.g., the breakeven rate advance for long-term
Treasuries is 20 bps (=330 bps ÷16.3 years).
E.g., the breakeven rate advance for the Barcap
U.S. Aggregate Bond Index is 45 bps (=235 bps ÷
5.2 years).
Note that these breakeven rate advances have
increased just a bit from their lows in late 2012.
Note further, however, that year-to-date 2013
returns are decidedly negative as the Barcap
Intermediate Treasury Index is off 1.28% for the
year while the Long Treasury Index is down 7.83%
for the year.
Shape of Yield Curve
The Fed reacted quickly and decisively to the
subprime crisis by injecting massive liquidity into the
system. The target Fed Funds rate was reduced in
2008 from 5-¼% to the current level of zero to ¼%.
But after the Fed moved rates (essentially) to zero,
it had apparently expended its major monetary
policy bullet with little positive impact.
Thus, it followed up with more inventive methods,
notably its “Quantitative Easing” (QE) programs that
continue to target the purchase of $40 billion of
mortgage securities and $45 billion in Treasuries on
a monthly basis.
But more recent events, as described above,
suggest that the Fed may relent in its innovative
easing programs. Markets reacted by pushing up
medium- to long-term yields, focusing on the 10-
year sector of the curve which ended the quarter
near 2-1/2% - see Table 1 below. This action
resulted in those large losses as described above in
2013 on a year-to-date basis. Thus, we have seen
a steepening in the curve driven by these rate
advances.
The economic optimism manifest in notional rates is
further reflected in real or inflation-adjusted rates of
return. Real yields associated with Treasury
Inflation Protected Securities (TIPS) have risen quite
a lot from recently recorded extreme lows. The real
yield associated with the bellwether 10-year TIPS
ended the quarter at 0.53% and up substantially
from the -0.64% observed as the conclusion of the
1st quarter.
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
3-M
th6-M
th1-Y
r2-Y
r3-Y
r
5-Y
r
7-Y
r
10-Y
r
30-Y
r
Treasury Yield Curve
Jun-13 Mar-13 Dec-12 Sep-12
Jun-12 Mar-12 Dec-11 Sep-11
-1%
0%
1%
2%
3%
4%
5%
Jan-0
1
Jan-0
2
Jan-0
3
Jan-0
4
Jan-0
5
Jan-0
6
Jan-0
7
Jan-0
8
Jan-0
9
Jan-1
0
Jan-1
1
Jan-1
2
Jan-1
3
Treasury Yield Spreads
2-5 Yr Spread 2-10 Yr Spread2-30 Yr Spread 5-10 Yr Spread5-30 Yr Spread 10-30 Yr Spread
-2%
-1%
0%
1%
2%
3%
4%
5%
Jan-0
3
Jan-0
4
Jan-0
5
Jan-0
6
Jan-0
7
Jan-0
8
Jan-0
9
Jan-1
0
Jan-1
1
Jan-1
2
Jan-1
3
TIPS Yields
5-Yr TIPS 7-Yr TIPS 10-Yr TIPS20-Yr TIPS 30-Yr TIPS
7 | Interest Rate Market Monitor 2nd Quarter 2013 | July 8, 2013 | © CME GROUP
Credit Risk
Credit risk refers to the risk of default associated
with a fixed income security, i.e., the risk that the
issuer will fail to make timely coupon and principle
payments. This risk may be monitored and traded
by reference to spreads between instruments
bearing divergent credit qualities.
E.g., one may compare the yields associated with
corporate bonds of varying credit quality to the
yields associated with comparable maturity Treasury
securities. This represents a classic comparison of
private vs. public credit risks. As a rule, of course,
the corporate securities should offer a more
attractive yield to compensate for the enhanced risk
of default.
The Moody’s Corporate Bond Indexes cover
investment grade securities with credit qualities
ranging from Baa to Aaa. Moody’s targets bonds
with remaining maturities as close to 30 years as
possible. Securities are deleted from the indexes if
their remaining maturity falls below 20 years, if the
security is susceptible to redemption or if the rating
should be amended.
By the conclusion of the 2nd quarter 2013, Aaa and
Baa corporate bond yields, as measured by the
Moody’s Indexes, were up to 4.32% and 5.35%,
respectively. This compares to the figures of 3.90%
and 4.83% seen at the end of the 1st quarter. These
figures might be further be compared to the yields
of 2.487% and 3.500% associated with on-the-run
(OTR) 10- and 30-year Treasuries. Thus, corporate
over Treasury yield spreads appear to be rallying in
another sign of an improving economic environment.
Fixed income portfolio managers must, of course,
decide whether to allocate assets to Treasury or
corporate securities. One critical central question
becomes – how many basis points must the spread
between corporates and Treasuries widen before
corporates actually underperform Treasuries?
To provide some insight into this question, we may
create a simple corporate spread breakeven (B/E)
analysis for the Finance sector, as reported by
Bloomberg. This process is analogous to our
breakeven rate analysis as explained above.
Specifically, we divide the finance spread, or the
premium in corporate bond rates vs. comparable
maturity Treasury rates, by the duration associated
with those corporates. The result provides an
indication of the degree to which the spread must
widen before corporates underperform Treasuries.
5-Year Corporate Finance Spread B/E Analysis
(6/28/13)
Corporate
Quality
Duration
(Years)
Finance
Spread
vs. Treas
B/E
Spread
Advance
AA 4.9 0.82% 17 bps
A 4.9 1.01% 21 bps
BBB 4.9 1.97% 40 bps
BB 4.9 2.20% 45 bps
Source: Bloomberg
E.g., if the spread for AA corporate bonds should
increase by 17 basis points (bps) over the course of
the next 12 months, the returns associated with
corporates will underperform comparable maturity
Treasuries. This is calculated as the finance spread
in basis points divided by duration or 17 bps = (82
bps ÷ 4.9 years).
E.g., the breakeven spread advance for A-rated
corporates is 21 bps (=101 bps ÷ 4.9 years).
E.g., the breakeven spread advance for BBB
corporates is 40 bps (=197 bps ÷ 4.9 years).
E.g., the breakeven spread advance for BB
corporates is 45 bps (=220 bps ÷ 4.9 years).
3%
4%
5%
6%
7%
8%
9%
10%
Jan-0
1
Jan-0
2
Jan-0
3
Jan-0
4
Jan-0
5
Jan-0
6
Jan-0
7
Jan-0
8
Jan-0
9
Jan-1
0
Jan-1
1
Jan-1
2
Jan-1
3
Moody's Corporate Bond Indexes
Moody's Aaa Corp Moody's Aa CorpMoody's A Corp Moody's Baa Corp
8 | Interest Rate Market Monitor 2nd Quarter 2013 | July 8, 2013 | © CME GROUP
While still at relatively low levels, it does appear that
breakeven spread levels have turned the corner by
coming off their recent all-time lows. Still, that has
come at significant cost as returns for corporate
bond investment, like Treasuries, are significantly
negative on a year-to-date basis. Still, more risk
looms as the prospect for further rate advances
remains.
Other Credit Spreads
Two additional and interesting credit quality spreads
that bear watching include (1) swap spreads; and,
(2) the OIS-LIBOR spread.
A swap spread is a reference to a spread between
interest rate swaps (IRS) and Treasury securities.
Consider this a form of credit spread insofar as it
represents a direct comparison between the private
credit risks represented in IRS markets vs. public
credit risks represented in Treasury markets.
Our graphic depicts various swap spreads
constructed from data gleaned from the U.S.
Treasury Department’s daily H15 report. Thus, we
compare 2-, 5-, 10- and 30-year LIBOR-based
interest rate swap instruments to “Constant Maturity
Treasury” (CMT) yields.
These spreads tend to advance and decline as a
function of credit conditions and the general level of
macroeconomic concerns. Normally, one would
expect that the IRS instruments would carry a
higher yield than comparable maturity Treasuries.
But expected relationships do not always hold.
The 30-year swap spread had fallen well into
negative territory in the wake of the subprime
mortgage crisis, flying in the face of the historical
presumption that private credit risks and yields must
exceed public risks and yields. Some would suggest
acting upon this apparent mispricing by pursuing an
arbitrage transaction by buying long-term Treasuries
and paying fixed rate on 30-year interest rate swap
instruments.
But the Fed essentially backstopped the banking
industry during the subprime crisis while S&P
downgraded the credit rating of U.S. long-term
sovereign debt in August 2011, thereby causing the
implicit credit risks to converge to a degree.
The structure of IRS instruments may imply less risk
relative to long-term Treasuries as swaps do not
require an original exchange of principal values and
may be marked-to-market. Thus, some suggest
that the spread belongs in negative territory,
representing a proverbial “black swan” in practice.
Further explanation for this apparent pricing
anomaly may be found in the movement towards
liability-driven investment (LDI) strategies. Many
pension fund managers have increasingly turned to
long-term IRS, as an alternative to 30-year Treasury
investment, to match the maturities of their assets
with liabilities.
But, as a result of glimmers of economic optimism,
swap spreads including the 30-year spread have
advanced during the 1st quarter. While still in
negative territory, the 30-year swap spread
0
50
100
150
200
250
AA A BBB BB
Corporate Spread B/E Analysis(Basis Points)
Dec-08 Dec-10 Mar-13 Jun-13
Source: Bloomberg
-0.6%
-0.4%
-0.2%
0.0%
0.2%
0.4%
0.6%
Jan-1
1
Mar-
11
May-1
1
Jul-
11
Sep-1
1
Nov-1
1
Jan-1
2
Mar-
12
May-1
2
Jul-
12
Sep-1
2
Nov-1
2
Jan-1
3
Mar-
13
May-1
3
Swap over Treasury Spreads
2-Yr Spread 5-Yr Spread
10-Yr Spread 30-Yr Spread
9 | Interest Rate Market Monitor 2nd Quarter 2013 | July 8, 2013 | © CME GROUP
advanced to -0.04% from the figure of -0.16% seen
near the conclusion of 2012.
Note that CME Group now offers 2-, 5-, 10- and 30-
year deliverable swap futures contracts (DSFs) as
well as Treasury futures contracts covering the 2-,
5-, 10- and 30-year sectors of the curve. Thus, one
may construct a weighted spread to take advantage
of risk-on, risk-off conditions.
Credit Quality
Increasing ����
Buy DSF / Treasury futures spreads
Credit Quality Decreasing
���� Sell DSF / Treasury
futures spreads
If you believed that economic tensions are
dissipating and wanted to adopt an aggressive “risk-
on” posture, some suggest buying DSF/Treasury
spreads. If you believed that economic tensions
might flare up, then one might adopt a conservative
“risk-off” position by selling DSF/Treasury spreads.
On the short-end of the yield curve, one may
monitor the spread between 3-month LIBOR and
Overnight Interest Swap (OIS) rates.
LIBOR is an acronym for London Interbank Offered
Rate and represents the rate paid by commercial
banks (in London) on U.S. dollar denomianted
deposits. OIS represents the rate paid on overnight
deposits by a central bank such as the U.S. Federal
Reserve to its member banks, i.e., the Fed Funds
rate, as observed and compounded over a period of
time such as three months.
To the extent that this spread gauges the difference
between commercial bank and central bank deposit
rates, it reflects the risk of default on the part of
commercial banks.
This spread has historically been observed around
10 basis points. But it rocketed to 3.5% at the
height of the subprime mortgage crisis. While the
European sovereign debt crisis does not hit quite so
close to home, the spread nonetheless spiked in mid
2010 and is moved up again in 2011 and in reaction
the European sovereign debt situation.
The LIBOR-OIS spread has actually been quite
stable over the course of 2013 to date. It ended the
2nd quarter at 16 basis points and very narrowly
changed from the 14 basis points and 16 basis
points seen at the end of the 1st and 4th quarters,
respectively. This stability is consistent with
indications of economic recovery and stabilizing
credit conditions.
CME Group offers 3-month Eurodollar futures based
on the British Bankers Association (BBA) 3-month
Eurodollar time deposit rate; and futures based on
30-day Federal Funds rate. Thus, a properly
weighted spread between Eurodollar and Fed Funds
futures may represent a nice proxy for the 3-month
LIBOR vs. OIS spread.
Credit Quality
Increasing ����
Buy Eurodollar / Fed Funds futures spreads
Credit Quality Decreasing
���� Sell Eurodollar / Fed Funds
futures spreads
If you believed that economic tensions were likely to
dissipate and wanted to adopt an aggressive risk-on
position, some suggest buying buy Eurodollar/Fed
Fund spreads. If you believed that economic
tensions might flare up, then one might adopt a
conservative risk-off position by selling
Eurodollar/Fed Funds spreads.
Conclusion
CME Group offers a broad array of interest rate
futures and option contracts running the gamut from
short-term to long-term contracts and reflecting
both public to private credit risks. These products
provide facile and liquid vehicles with which one may
express a view on prospective market movements.
Or, to manage the risks associated with fixed income
holdings during turbulent times.
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
Jan-0
7
Jun-0
7
Nov-0
7
Apr-
08
Sep-0
8
Feb-0
9
Jul-
09
Dec-0
9
May-1
0
Oct-
10
Mar-
11
Aug-1
1
Jan-1
2
Jun-1
2
Nov-1
2
Apr-
13
3-Mth LIBOR - OIS Spread
10 | Interest Rate Market Monitor 2nd Quarter 2013 | July 8, 2013 | © CME GROUP
Table 1: Treasury On-the-Runs (OTRs) (As of 6/28/13)
Coupon Maturity Price Yield Duration (Years)
BPV (per Mil)
Yield (Mar-13)
Yield (Dec-12)
Yield (Sep-12)
Yield (Jun-12)
4-Wk Bill 07/25/13 0.008% 0.066 $6.58 0.028% 0.018%
13-Wk Bill 09/26/13 0.033% 0.238 $23.84 0.074% 0.043% 0.073% 0.083%
26-Wk Bill 12/26/13 0.093% 0.488 $48.77 0.104% 0.114% 0.133% 0.153%
52-Wk Bill 06/26/14 0.143% 0.986 $98.63 0.124% 0.140% 0.155% 0.206%
2-Yr Note 3/8% 06/30/15 100-01 1/8 0.349% 1.985 $199 0.244% 0.248% 0.232% 0.303%
3-Yr Note 1/2% 06/15/16 99-18 1/8 0.648% 2.936 $292 0.035% 0.353% 0.307% 0.395%
5-Yr Note 1-3/8% 06/30/18 99-28 7/8 1.395% 4.813 $481 0.765% 0.724% 0.626% 0.719%
7-Yr Note 1-7/8% 06/30/20 99-18 1.942% 6.525 $650 1.238% 1.180% 1.050% 1.106%
10-Yr Note 1-3/4% 05/15/23 93-18 3/4 2.487% 8.945 $839 1.850% 1.758% 1.634% 1.646%
30-Yr Bond 2-7/8% 05/15/43 88-15 3.500% 19.140 $1,700 3.103% 2.950% 2.824% 2.754%
Table 2: Treasury OTR Yield Spreads (As of 6/28/13)
Jun-13 Mar-13 Dec-12 Sep-12 Jun-12
Yield Spreads
2-5 Yr 1.046% 0.521% 0.476% 0.394% 0.416%
2-10 Yr 2.138% 1.606% 1.510% 1.402% 1.343%
2-30 Yr 3.151% 2.859% 2.702% 2.592% 2.451%
5-10 Yr 1.092% 1.085% 1.034% 1.008% 0.927%
5-30 Yr 2.105% 2.338% 2.226% 2.198% 2.035%
10-30 Yr 1.013% 1.253% 1.192% 1.190% 1.108%
Butterflies
2-5-10 Yr 0.046% 0.564% 0.558% 0.614% 0.511%
2-5-30 Yr 1.059% 1.817% 1.750% 1.804% 1.619%
Copyright 2013 CME Group All Rights Reserved. Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only a percentage of a contract’s value is
required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a
portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. All examples in this brochure are hypothetical situations, used for explanation purposes only, and should not
be considered investment advice or the results of actual market experience.”
Swaps trading is not suitable for all investors, involves the risk of loss and should only be undertaken by investors who are ECPs within the meaning of section 1(a)18 of the Commodity Exchange Act. Swaps are a
leveraged investment, and because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for a swaps position. Therefore, traders should only use funds
that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade.
CME Group is a trademark of CME Group Inc. The Globe logo, E-mini, Globex, CME and Chicago Mercantile Exchange are trademarks of Chicago Mercantile Exchange Inc. Chicago Board of Trade is a trademark of the Board
of Trade of the City of Chicago, Inc. NYMEX is a trademark of the New York Mercantile Exchange, Inc.
The information within this document has been compiled by CME Group for general purposes only and has not taken into account the specific situations of any recipients of the information. CME Group assumes no
responsibility for any errors or omissions. Additionally, all examples contained herein are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual
market experience. All matters pertaining to rules and specifications herein are made subject to and are superseded by official CME, NYMEX and CBOT rules. Current CME/CBOT/NYMEX rules should be consulted in all cases
before taking any action.