Interest Rate Market Monitor, Quarterly Update Q1 2013

INTEREST RATES

Interest Rate Market Monitor 1st Quarter 2013

APRIL 6, 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 1st Quarter 2013 | April 6, 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

Fourth quarter 2012 GDP was most recently

reported at a somewhat disappointing +0.4%. But

the Federal Open Market Committee (FOMC)

attributed this figure, after a rather robust advance

of +3.1% in the 3rd quarter, to “weather-related

disruptions” with an obvious nod to Superstorm

Sandy “and other transitory factors” such as

inventory drawdowns. 1

The FOMC suggested more recently on March 20th

that we are now witnessing a “return to moderate

economic growth following a pause late last year.” 2

The Fed elaborates that while “[l]abor market

conditions have shown signs of improvement in

recent months … the unemployment rate remains

elevated.” 3 Unemployment is winding down,

reported at 7.6% for March 2013. But it does

remain significantly above the Fed’s target of 6-½%.

The Fed does concede that it sees “downside risks to

the economic outlook.” Certainly these risks are

implied by the ongoing decline in labor force

participation, reported at 63.3% for March 2013.

Still, the Fed found solace in the facts that

“[h]ousehold spending and business fixed

investment advanced, and the housing sector has

strengthened further but fiscal policy has become

somewhat restrictive.” 4

Consumer sentiment has been buoyed in recent

months with the Michigan Index of Consumer

Sentiment reported at 77.6 in February 2013 and up

from 75.3 in February 2012. This sentiment is

reinforced by a decline in the personal savings rate

1 Federal Reserve Press Release dated January 30, 2013. 2 Federal Reserve Press Release dated March 20, 2013. 3 Ibid. 4 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)


to 2.4% in January 2013 from 6.4% in December

2012.

Further evidence of retail strength, accounting for

perhaps 70% of domestic economic growth, is found

in strong retail sales activity. The February 2013

retail sales report is the strongest figure on record,

topping numbers recorded in late 2007 before the

full weight of the subprime mortgage crisis was felt.

March housing activity figures were generally quite

upbeat with building permits rising to 946 thousand

units and housing starts up to 917 thousand units

and the highest levels recorded since 2008.

Further signs of growing momentum may be found

in housing values. The S&P/Case-Shiller Composite

Index of 10 U.S. cities was reported for January

2013 as 8.4% above the trough recorded in March

2013 but still 29.9% below the all-time peak from

June 2006.

This consumer optimism spilled over into the

industrial sector as the Index of Industrial

Production was recorded for February 2013 at its

highest level since April 2008. Similarly, capacity

utilization rose to 78.3% in February 2013. Still,

these figures fall a bit short of the peaks observed in

late 2007 and early 2008 just prior to the onset of

the subprime crisis.

55

60

65

70

75

80

85

90

95

100

1%

2%

3%

4%

5%

6%

7%

8%

9%

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

Consum

er

Confidence

Pers

onal Savin

gs R

ate

Personal Savings & Sentiment

Personal Savings Rate Consumer Sentiment Index

Source: FRED Database

1.20

1.25

1.30

1.35

1.40

1.45

1.50

$150

$155

$160

$165

$170

$175

$180

$185

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

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

0

500

1,000

1,500

2,000

2,500

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

000 U

nits

Housing Activity

Building Permits Housing Starts Completions

Source: Dept. of Housing & Urban Development (HUD)

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

S&P/Case-Shiller Housing Indexes

Los Angeles San Diego San Francisco

Denver Washington DC Miami

Chicago Boston Las Vegas

New York Comp-10

Source: Standard & Poor's


Industrial growth was further reflected in strong

corporate profitability. Third quarter 2012 corporate

profits were recorded at $1.74 trillion. This is an

advance of 17.9% over the 2nd quarter 2012 figure

and the highest observed performance yet to be

recorded.

Inflation

The Fed observed that “[i]nflation has been running

somewhat below the Committee’s longer-run

objective, apart from temporary variations that

largely reflect fluctuations in energy prices. Longer-

term inflation expectations have remained stable …

[t]he Committee also anticipates that inflation over

the medium term will run at or below its 2 percent

objective.” 5

5 Ibid.

Indeed, both CPI and CPI ex-food and energy prices

were recorded, on a seasonally adjusted (SA) basis,

at 2.0% in February 2013 and precisely equal to the

Fed’s stated objective.

Monetary Policy

The Fed suggests that “a highly accommodative

stance of monetary policy will remain appropriate for

a considerable time after the asset purchase

program ends and the economic recovery

strengthens … [thus, it is maintaining] … 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 6-½ 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 Fed policy on the very shortest end of the

curve remains fixed, they nonetheless “decided to

continue purchasing additional agency mortgage-

based securities at a pace of $40 billion per month

and longer-term Treasury securities at a pace of $45

billion per month … Taken together, these actions

should maintain downward pressure on longer-term

interest rates, support mortgage markets, and help

6 Ibid.

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

$600

$800

$1,000

$1,200

$1,400

$1,600

$1,800

-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

Pre

-Tax P

rofits

(Billions)

Annualized C

hange

U.S. Corporate Profitability

Annual Change Corporate Profits (Bil)

Source: Department of Commerce

-3%

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

Jan-0

4

Aug-0

4

Mar-

05

Oct-

05

May-0

6

Dec-0

6

Jul-

07

Feb-0

8

Sep-0

8

Apr-

09

Nov-0

9

Jun-1

0

Jan-1

1

Aug-1

1

Mar-

12

Oct-

12

Year-

on-Y

ear

Change

Consumer Price Index (CPI)

CPI - All Urban Consumers SACPI ex-Food & Energy SA

Source: Bureau of Labor Statistics (BLS)


to make broader financial conditions more

accommodative.” 7

Fiscal Policy

The Fed comments that “fiscal policy has become

somewhat restrictive.” 8 Certainly this restrictive

stance is reflected in a decline the Federal deficit for

2012 of $10.1 trillion. While this is a considerable

figure and far in excess of all previous deficits prior

to the onset of the subprime crisis, it nonetheless

represents some improvement over the deficits of

2009, 2010 and 2011.

Still, the budget battle in Washington is not over as

the gap between the Democratic and Republican

fiscal visions are far apart. This battle may reach

7 Ibid. 8 Ibid.

crisis proportions around May 19th when the next

debt limit crisis is projected to come to a head.

Entitlement spending, income and estate taxes and

the size of government remain controversial issues.

Current & Capital Account Flows

Just as incremental progress is achieved with

respect to the Federal spending deficit, we also see

some improvement with respect to the U.S. current

account or trade deficit. The 4th quarter 2012 deficit

was reported at $100.4 billion. While not altogether

cheerful, it represents a significant improvement on

the $133.8 billion deficit from the 1st quarter 2012

and is running at roughly half of the pre-crisis

deficits which peaked in 2006.

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.

Capital flowing out of the U.S. by domestic or

foreign investors was rather negligible during the

entirety of 2012. Some $105.2 billion, on a net

basis, flowed into the U.S. equity markets from

overseas in 2012. But the major story was the

continued inflow of funds into the U.S. Treasury

markets as overseas investors bought some $391.6

billion of Treasuries, on a net basis, in 2012.

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 Treasury

5-Yr Treasury 10-Yr Treasury

30-Yr Treasury

-$1,600

-$1,400

-$1,200

-$1,000

-$800

-$600

-$400

-$200

$0

$200

$400

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Federal Surplus/Deficit(Billions USD)

Source: Office of Management and Budget (OMB)

-$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

U.S. Current Account Deficit(Billions USD)

Source: Bureau of Economic Analysis (BEA)


Still, this represents a significant decline from the

$703.7 billion flowing into Treasuries in 2010.

Clearly, U.S. Treasuries continue to be regarded as a

“safe haven” investment that is highly valued by

foreign investors, despite generally low yields.

Outright Yield Movements

Interest rates have come off of the extreme lows

that have been observed in recent months and

years. Still, we remain at very low levels, prompting

some observers to suggest that the only direction in

which the next major interest rate movement can

occur is up. This, of course, 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

(3/28/13)

Barcap

Index

2012

YTD

Return

Duration

(Years) Yield

B/E

Rate

Advance

U.S.

Treasury 1.99% 5.3 0.89% 17 bps

Intermediate

Treasury 1.71% 3.7 0.61% 16

Long

Treasury 3.56% 16.7 2.87% 17

Aggregate 4.22% 5.2 1.87% 36

E.g., if rates advance just 17 basis points (bps) or

0.17% 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 16 bps = (89 bps

÷ 5.3 years).

E.g., the breakeven rate advance for intermediate

Treasuries is 16 bps (=61 bps ÷ 3.7 years).

E.g., the breakeven rate advance for long-term

Treasuries is 17 bps (=287 bps ÷16.7 years).

E.g., the breakeven rate advance for the Barcap

U.S. Aggregate Bond Index is 36 bps (=187 bps ÷

5.2 years).

-$800

-$300

$200

$700

$1,2002003

2004

2005

2006

2007

2008

2009

2010

2011

2012

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 Mar-13

Source: Bloomberg


These breakeven rate advances are near the lowest

levels ever observed. This analysis underscores the

vulnerability associated with fixed income securities

and represents a significant source of concern,

particularly in light of the magnitude of planned

Treasury issuance.

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” programs known as

“QE” and “QE2” – followed by the latest round

focusing on mortgage backed securities.

The net effect of these monetary policies is that, in

addition to contributing to a very bloated Fed

balance sheet, we currently have very low nominal

interest rates across the entire maturity spectrum of

the yield curve, i.e., a reasonably flat yield curve.

Yield spreads are now quite compressed at any

level. (See Table 1 below.)

However, signs of economic recovery during the 1st

quarter have stimulated some yield advances in the

longer maturities. While these movements have

been rather slight, we nonetheless observe a slight

steepening of the yield curve from Dec-12 to Mar-

13. This effect is further reflected in various

Treasury yield spreads as depicted below.

This economic optimism observed in notional rates is

further reflected in real rates as well. Note that real,

or inflation-adjusted, yields associated Treasury

Inflation Protected Securities (TIPS) have risen a bit

from recently recorded extreme lows. In particular,

real yields associated with 5-year TIPS rose -1.03%

by the conclusion of the 1st quarter from -1.33% in

Oct-12.

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

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

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

Mar-13 Dec-12 Sep-12 Jun-12

Mar-12 Dec-11 Sep-11 Jun-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


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 1st quarter 2013, Aaa and

Baa corporate bond yields, as measured by the

Moody’s Indexes, were at 3.90% and 4.83%,

climbing from 3.67% and 4.63%, respectively, as of

the conclusion of the 4th quarter 2012. These

figures might be compared to the yields of 1.850%

and 3.103% associated with on-the-run (OTR) 10-

and 30-year Treasuries.

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 (12/31/12)

Corporate

Quality

Duration

(Years)

Finance

Spread

vs. Treas

B/E

Spread

Advance

AA 4.9 0.71% 14 bps

A 4.9 0.75% 15

BBB 4.9 1.76% 36

BB 4.9 2.01% 41

Source: Bloomberg

E.g., if the spread for AA corporate bonds should

increase by 14 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 14 bps = (71

bps ÷ 4.9 years).

E.g., the breakeven spread advance for A-rated

corporates is 15 bps (=75 bps ÷ 4.9 years).

E.g., the breakeven spread advance for BBB


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

0

50

100

150

200

250

AA A BBB BB

Corporate Spread B/E Analysis(Basis Points)

Dec-08 Dec-10 Mar-13

Source: Bloomberg


E.g., the breakeven spread advance for BB


Note that the current B/E spread advance figures

are at the lowest levels observed for some years

now. In fact, the cushion declined significantly over

the 1st quarter 2013. I.e., corporate investors may

be more vulnerable to the prospect of widening

credit spreads today than ever before.

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 reduced

risk relative to long-term Treasuries as swaps do not

contemplate 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

advanced to -0.10% from -0.16 over the course of

the 1st quarter 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

-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

Swap over Treasury Spreads

2-Yr Spread 5-Yr Spread

10-Yr Spread 30-Yr Spread


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 declined to 0.14% from

0.16% during the course of the 1st quarter 2012.

This 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

3-Mth LIBOR - OIS Spread


Table 1: Treasury On-the-Runs (OTRs) (As of 3/28/13)

Coupon Maturity Price Yield Duration (Years)

BPV (per Mil)

Yield (Dec-12)

Yield (Sep-12)

Yield (Jun-12)

Yield (Mar-12)

Yield (Dec-11)

4-Wk Bill 04/25/13 0.028% 0.066 $6.58 0.018%

13-Wk Bill 06/27/13 0.074% 0.238 $23.83 0.043% 0.073% 0.083% 0.08% 0.01%

26-Wk Bill 09/26/13 0.104% 0.487 $48.72 0.114% 0.133% 0.153% 0.14% 0.05%

52-Wk Bill 03/06/14 0.124% 0.928 $92.72 0.140% 0.155% 0.206% 0.19% 0.12%

2-Yr Note 1/4% 03/31/15 100-00 3/8 0.244% 1.986 $199 0.248% 0.232% 0.303% 0.34% 0.26%

3-Yr Note 3/8% 03/15/16 100-02 3/8 0.035% 2.929 $293 0.353% 0.307% 0.395% 0.51% 0.39%

5-Yr Note 3/4% 03/31/18 99-29 5/8 0.765% 4.890 $489 0.724% 0.626% 0.719% 1.02% 0.89%

7-Yr Note 1-1/8% 03/31/20 99-07 7/8 1.238% 6.700 $665 1.180% 1.050% 1.106% 1.56% 1.43%

10-Yr Note 2% 02/15/23 101-11 1/4 1.850% 8.908 $905 1.758% 1.634% 1.646% 2.17% 1.98%

30-Yr Bond 3-1/8% 02/15/43 100-13+ 3.103% 19.276 $1,944 2.950% 2.824% 2.754% 3.28% 2.98%

Table 2: Treasury OTR Yield Spreads (As of 3/28/13)

Mar-13 Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Sep-11

Yield Spreads

2-5 Yr 0.521% 0.476% 0.394% 0.416% 0.68% 0.62% 0.69%

2-10 Yr 1.606% 1.510% 1.402% 1.343% 1.83% 1.66% 1.77%

2-30 Yr 2.859% 2.702% 2.592% 2.451% 2.94% 2.66% 2.97%

5-10 Yr 1.085% 1.034% 1.008% 0.927% 1.15% 1.04% 1.08%

5-30 Yr 2.338% 2.226% 2.198% 2.035% 2.26% 2.04% 2.28%

10-30 Yr 1.253% 1.192% 1.190% 1.108% 1.11% 1.00% 1.20%

Butterflies

2-5-10 Yr 0.564% 0.558% 0.614% 0.511% 0.47% 0.42% 0.39%

2-5-30 Yr 1.817% 1.750% 1.804% 1.619% 1.58% 1.42% 1.59%

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, Quarterly Update Q1 2013