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

[email protected]

Interest Rate Products

312-466-7473

[email protected]

http://www.cmegroup.com

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)


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


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


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)


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


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


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


E.g., the breakeven spread advance for BB


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


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


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


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.

Economy & Finance

Interest Rate Market Monitor 2nd Quarter 2013