Interest Rate Market Monitor, Quarterly Update Q1 2013


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Breakeven rate advances, a measure of the risk from rising interest rates, remained near the lowest levels ever observed during the first three months of 2013, CME Group directors John Labuszewski and Michael Kamradt said in a report.

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Interest Rate Market Monitor, Quarterly Update Q1 2013

  1. 1. INTEREST RATESInterest Rate Market Monitor1st Quarter2013APRIL 6, 2013John W. Labuszewski Michael KamradtManaging Director Executive DirectorResearch & Product Development Interest Rate Products312-466-7469
  2. 2. Fixed income market participants may trade based disruptions” with an obvious nod to Superstormupon performance expectations couched along Sandy “and other transitory factors” such asseveral dimensions including outright yield inventory drawdowns. 1movements, changes in the shape of the yield curve,dynamic credit risks as well as volatility The FOMC suggested more recently on March 20thconsiderations. that we are now witnessing a “return to moderate economic growth following a pause late last year.” 2CME Group offers interest rate futures and options The Fed elaborates that while “[l]abor marketthat allow one to engage in trading activities driven conditions have shown signs of improvement inby any of these significant factors. Our offerings recent months … the unemployment rate remainsincludes Eurodollar, Treasury, Fed Funds, Swap and elevated.” 3 Unemployment is winding down,other interest rate products covering the entire reported at 7.6% for March 2013. But it doesspectrum of the yield curve, representing both public remain significantly above the Fed’s target of 6-½%.and private credit risks. Further, our offeringsinclude options on the most popular of our interest Employment Statistics 11% 67%rate futures contracts. Labor Force Participation 10%This document represents a review of these factors Unemployment Rate 66% 9%as they played out in the most recently completed 8%calendar quarter and the impact they have exerted 65%on CME Group interest rate products. We begin with 7%a review of fundamental economic conditions as a 6% 64%backdrop of how this impacts upon outright yield 5%movements, the shape of the curve and credit 4% 63%considerations. Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Growth and Employment 6% 11% Unemployment Rate Labor Force Partcipation 4% 10% Source: Bureau of Labor Statistics (BLS) Qtrly Change in GDP Unemployment Rate 2% 9% 0% The Fed does concede that it sees “downside risks to 8% -2% the economic outlook.” Certainly these risks are 7% -4% implied by the ongoing decline in labor force -6% 6% participation, reported at 63.3% for March 2013. -8% 5% -10% 4% Still, the Fed found solace in the facts that 05 05 06 06 07 07 08 08 09 09 10 10 11 11 12 12 13 “[h]ousehold spending and business fixed Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 investment advanced, and the housing sector has Real GDP (SA) Unemployment Rate strengthened further but fiscal policy has become Source: Bureau of Economic Analysis (BEA) somewhat restrictive.” 4 & Bureau of Labor Statistics (BLS) Consumer sentiment has been buoyed in recentGrowth and Employment months with the Michigan Index of Consumer Sentiment reported at 77.6 in February 2013 and upFourth quarter 2012 GDP was most recently from 75.3 in February 2012. This sentiment isreported at a somewhat disappointing +0.4%. But reinforced by a decline in the personal savings ratethe Federal Open Market Committee (FOMC)attributed this figure, after a rather robust advanceof +3.1% in the 3rd quarter, to “weather-related 1 Federal Reserve Press Release dated January 30, 2013. 2 Federal Reserve Press Release dated March 20, 2013. 3 Ibid. 4 Ibid.1 | Interest Rate Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
  3. 3. to 2.4% in January 2013 from 6.4% in December Housing Activity2012. 2,500 2,000 Personal Savings & Sentiment 9% 100 000 Units 1,500 8% 95 Personal Savings Rate Consumer Confidence 7% 90 1,000 85 6% 80 500 5% 75 4% 0 70 Sep-04 Sep-06 Sep-08 Sep-10 Sep-12 Jan-04 May-05 Jan-06 May-07 Jan-08 May-09 Jan-10 May-11 Jan-12 3% 65 2% 60 1% 55 Building Permits Housing Starts Completions Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 Source: Dept. of Housing & Urban Development (HUD) Personal Savings Rate Consumer Sentiment Index Further signs of growing momentum may be found Source: FRED Database in housing values. The S&P/Case-Shiller Composite Index of 10 U.S. cities was reported for JanuaryFurther evidence of retail strength, accounting for 2013 as 8.4% above the trough recorded in Marchperhaps 70% of domestic economic growth, is found 2013 but still 29.9% below the all-time peak fromin strong retail sales activity. The February 2013 June 2006.retail sales report is the strongest figure on record,topping numbers recorded in late 2007 before the S&P/Case-Shiller Housing Indexes 320full weight of the subprime mortgage crisis was felt. 280 Retail Sector Activity $185 1.50 240 200 Inventory:Sales Ratio $180 1.45 Retail Sales (Bil $) $175 160 1.40 $170 1.35 120 $165 1.30 80 $160 Sep-01 Sep-06 Sep-11 Jan-00 Nov-00 Jul-02 May-03 Mar-04 Jan-05 Nov-05 Jul-07 May-08 Mar-09 Jan-10 Nov-10 Jul-12 $155 1.25 $150 1.20 Los Angeles San Diego San Francisco Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Denver Washington DC Miami Chicago Boston Las Vegas New York Comp-10 Source: Standard & Poors Real Retail Sales & Food Services SA Total Business Inventory:Sales Ratio Source: U.S. Census Bureau This consumer optimism spilled over into the industrial sector as the Index of IndustrialMarch housing activity figures were generally quite Production was recorded for February 2013 at itsupbeat with building permits rising to 946 thousand highest level since April 2008. Similarly, capacityunits and housing starts up to 917 thousand units utilization rose to 78.3% in February 2013. Still,and the highest levels recorded since 2008. 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.2 | Interest Rate Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
  4. 4. Industrial Sector Activity Indeed, both CPI and CPI ex-food and energy prices 105 82% were recorded, on a seasonally adjusted (SA) basis, Industrial Production Index 80% at 2.0% in February 2013 and precisely equal to the 100 Capacity Utilization 78% Fed’s stated objective. 95 76% 74% 90 Consumer Price Index (CPI) 72% 6% 70% 85 5% Year-on-Year Change 68% 4% 80 66% 3% Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 2% 1% Index of Industrial Production Capacity Utilization 0% Source: St. Louis Federal Reserve FRED Database -1% -2%Industrial growth was further reflected in strong -3% Aug-04 Dec-06 Sep-08 Aug-11 Jan-04 Mar-05 Oct-05 May-06 Jul-07 Feb-08 Apr-09 Nov-09 Jun-10 Jan-11 Mar-12 Oct-12corporate profitability. Third quarter 2012 corporateprofits were recorded at $1.74 trillion. This is anadvance of 17.9% over the 2nd quarter 2012 figure CPI - All Urban Consumers SAand the highest observed performance yet to be CPI ex-Food & Energy SA Source: Bureau of Labor Statistics (BLS)recorded. Monetary Policy U.S. Corporate Profitability 120% $1,800 100% The Fed suggests that “a highly accommodative Pre-Tax Profits (Billions) $1,600 stance of monetary policy will remain appropriate for Annualized Change 80% a considerable time after the asset purchase 60% $1,400 program ends and the economic recovery 40% $1,200 strengthens … [thus, it is maintaining] … the target 20% range for the federal funds rate at 0 to ¼ percent 0% $1,000 and currently anticipates that this exceptionally low -20% $800 range … will be appropriate at least as long as the -40% unemployment rate remains above 6-½ percent, -60% $600 inflation between one and two years ahead is Q1 04 Q4 04 Q3 05 Q2 06 Q1 07 Q4 07 Q3 08 Q2 09 Q1 10 Q4 10 Q3 11 Q2 12 projected to be no more than a half percentage point above the Committee’s 2 percent longer-run Annual Change Corporate Profits (Bil) goal, and longer-term inflation expectations continue Source: Department of Commerce to be well anchored.” 6Inflation While Fed policy on the very shortest end of the curve remains fixed, they nonetheless “decided toThe Fed observed that “[i]nflation has been running continue purchasing additional agency mortgage-somewhat below the Committee’s longer-run based securities at a pace of $40 billion per monthobjective, apart from temporary variations that and longer-term Treasury securities at a pace of $45largely reflect fluctuations in energy prices. Longer- billion per month … Taken together, these actionsterm inflation expectations have remained stable … should maintain downward pressure on longer-term[t]he Committee also anticipates that inflation over interest rates, support mortgage markets, and helpthe medium term will run at or below its 2 percentobjective.” 55 6 Ibid. Ibid.3 | Interest Rate Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
  5. 5. to make broader financial conditions more crisis proportions around May 19th when the nextaccommodative.” 7 debt limit crisis is projected to come to a head. Entitlement spending, income and estate taxes and Benchmark U.S. Rates the size of government remain controversial issues. 7% 6% Current & Capital Account Flows 5% 4% Just as incremental progress is achieved with respect to the Federal spending deficit, we also see 3% some improvement with respect to the U.S. current 2% account or trade deficit. The 4th quarter 2012 deficit 1% was reported at $100.4 billion. While not altogether 0% cheerful, it represents a significant improvement on the $133.8 billion deficit from the 1st quarter 2012 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 and is running at roughly half of the pre-crisis deficits which peaked in 2006. Target Fed Funds 2-Yr Treasury 5-Yr Treasury 10-Yr Treasury 30-Yr Treasury Another interesting source of flow of funds data may be found in the U.S. Treasury Department’sFiscal Policy Treasury International Capital (or “TIC”) database. This database tracks flows into and out of the U.S.The Fed comments that “fiscal policy has become The data is broken into foreign stocks, foreignsomewhat restrictive.” 8 Certainly this restrictive bonds, U.S. stocks, U.S. corporate bonds, U.S.stance is reflected in a decline the Federal deficit for government agencies and U.S. Treasuries.2012 of $10.1 trillion. While this is a considerablefigure and far in excess of all previous deficits prior U.S. Current Account Deficit (Billions USD)to the onset of the subprime crisis, it nonetheless $0represents some improvement over the deficits of2009, 2010 and 2011. -$50 Federal Surplus/Deficit -$100 (Billions USD) $400 $200 -$150 $0 -$200 -$200 -$400 -$250 -$600 04 04 05 05 06 06 07 07 08 08 09 09 10 10 11 11 12 12 -$800 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 -$1,000 Source: Bureau of Economic Analysis (BEA) -$1,200 -$1,400 Capital flowing out of the U.S. by domestic or -$1,600 foreign investors was rather negligible during the 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 entirety of 2012. Some $105.2 billion, on a net Source: Office of Management and Budget (OMB) basis, flowed into the U.S. equity markets from overseas in 2012. But the major story was theStill, the budget battle in Washington is not over as continued inflow of funds into the U.S. Treasurythe gap between the Democratic and Republican markets as overseas investors bought some $391.6fiscal visions are far apart. This battle may reach billion of Treasuries, on a net basis, in 2012.7 Ibid.8 Ibid.4 | Interest Rate Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
  6. 6. Net US/Foreign Capital Flows This analysis is generally conducted over a twelve- (Billions USD) $1,200 month time horizon and takes into account any income generated by holding the security. One may estimate the rate advance required to offset income $700 over a 12-month period by simply dividing the yield on the index by its duration. $200 Breakeven Rate Analysis (3/28/13) -$300 2012 B/E Barcap Duration YTD Yield Rate Index (Years) -$800 Return Advance U.S. 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 1.99% 5.3 0.89% 17 bps Treasury US Treasuries US Govt Agencies US Corporates Intermediate 1.71% 3.7 0.61% 16 US Stocks Foreign Bonds Foreign Stocks Treasury Source: U.S. Treasury TIC Database Long 3.56% 16.7 2.87% 17 Treasury Aggregate 4.22% 5.2 1.87% 36Still, this represents a significant decline from the$703.7 billion flowing into Treasuries in 2010. E.g., if rates advance just 17 basis points (bps) orClearly, U.S. Treasuries continue to be regarded as a 0.17% on all securities in the U.S. Treasury Index“safe haven” investment that is highly valued by over the course of the next 12 months, the returnsforeign investors, despite generally low yields. associated with the index will equate to zero, or the breakeven point. This is calculated as the yield inOutright Yield Movements basis points divided by duration or 16 bps = (89 bps ÷ 5.3 years).Interest rates have come off of the extreme lowsthat have been observed in recent months and Breakeven Rate Analysisyears. Still, we remain at very low levels, prompting (Basis Points)some observers to suggest that the only direction in 250which the next major interest rate movement canoccur is up. This, of course, implies declining fixed 200income asset values and represents a further sourceof global risk as explained in more detail below. 150We might measure the prospective risk of rising 100rates by resorting to an analysis known as“breakeven (B/E) rate analysis.” This technique 50addresses the questions – how much do rates needto advance, measured in basis points (bps), before 0investors suffers a loss by holding a particular U.S. Treas Inter Treas Long Treas Aggregatesecurity or portfolio? Dec-99 Dec-07 Mar-13 Source: BloombergIn order to address this question in a currentcontext, we examined the characteristics of various E.g., the breakeven rate advance for intermediateindexes as published by Barclays Capital including Treasuries is 16 bps (=61 bps ÷ 3.7 years).the U.S. Treasury Index (inclusive of all maturities);the Intermediate Treasury Index (1-10 year E.g., the breakeven rate advance for long-termmaturities); the Long Treasury Index (10+ year Treasuries is 17 bps (=287 bps ÷16.7 years).maturities); and the Aggregate Index (includesmortgages and corporates). E.g., the breakeven rate advance for the Barcap U.S. Aggregate Bond Index is 36 bps (=187 bps ÷ 5.2 years).5 | Interest Rate Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
  7. 7. These breakeven rate advances are near the lowest 13. This effect is further reflected in variouslevels ever observed. This analysis underscores the Treasury yield spreads as depicted below.vulnerability associated with fixed income securitiesand represents a significant source of concern,particularly in light of the magnitude of planned Treasury Yield Spreads 5%Treasury issuance. 4%Shape of Yield Curve 3%The Fed reacted quickly and decisively to the 2%subprime crisis by injecting massive liquidity into thesystem. The target Fed Funds rate was reduced in 1%2008 from 5-¼% to the current level of zero to ¼%. 0%But after the Fed moved rates (essentially) to zero,it had apparently expended its major monetary -1% Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13policy bullet with little positive impact. Treasury Yield Curve 2-5 Yr Spread 2-10 Yr Spread 2-30 Yr Spread 5-10 Yr Spread 4.5% 5-30 Yr Spread 10-30 Yr Spread 4.0% 3.5% This economic optimism observed in notional rates is 3.0% further reflected in real rates as well. Note that real, 2.5% or inflation-adjusted, yields associated Treasury 2.0% Inflation Protected Securities (TIPS) have risen a bit 1.5% from recently recorded extreme lows. In particular, 1.0% real yields associated with 5-year TIPS rose -1.03% by the conclusion of the 1st quarter from -1.33% in 0.5% Oct-12. 0.0% 1-Yr 2-Yr 3-Yr 5-Yr 7-Yr 10-Yr 30-Yr 3-Mth 6-Mth TIPS Yields 5% Mar-13 Dec-12 Sep-12 Jun-12 Mar-12 Dec-11 Sep-11 Jun-11 4% 3%Thus, it followed up with more inventive methods, 2%notably its “Quantitative Easing” programs known as“QE” and “QE2” – followed by the latest round 1%focusing on mortgage backed securities. 0% -1%The net effect of these monetary policies is that, in -2%addition to contributing to a very bloated Fed Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13balance sheet, we currently have very low nominalinterest rates across the entire maturity spectrum ofthe yield curve, i.e., a reasonably flat yield curve. 5-Yr TIPS 7-Yr TIPS 10-Yr TIPS 20-Yr TIPS 30-Yr TIPSYield spreads are now quite compressed at anylevel. (See Table 1 below.) Credit RiskHowever, signs of economic recovery during the 1st Credit risk refers to the risk of default associatedquarter have stimulated some yield advances in the with a fixed income security, i.e., the risk that thelonger maturities. While these movements have issuer will fail to make timely coupon and principlebeen rather slight, we nonetheless observe a slight payments. This risk may be monitored and tradedsteepening of the yield curve from Dec-12 to Mar-6 | Interest Rate Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP
  8. 8. by reference to spreads between instruments To provide some insight into this question, we maybearing divergent credit qualities. create a simple corporate spread breakeven (B/E) analysis for the Finance sector, as reported byE.g., one may compare the yields associated with Bloomberg. This process is analogous to ourcorporate bonds of varying credit quality to the breakeven rate analysis as explained above.yields associated with comparable maturity Treasury Specifically, we divide the finance spread, or thesecurities. This represents a classic comparison of premium in corporate bond rates vs. comparableprivate vs. public credit risks. As a rule, of course, maturity Treasury rates, by the duration associatedthe corporate securities should offer a more with those corporates. The result provides anattractive yield to compensate for the enhanced risk indication of the degree to which the spread mustof default. widen before corporates underperform Treasuries.The Moody’s Corporate Bond Indexes cover 5-Year Corporate Finance Spread B/E Analysis (12/31/12)investment grade securities with credit qualitiesranging from Baa to Aaa. Moody’s targets bonds Finance B/E Corporate Durationwith remaining maturities as close to 30 years as Spread Spread Quality (Years) vs. Treas Advancepossible. Securities are deleted from the indexes if AA 4.9 0.71% 14 bpstheir remaining maturity falls below 20 years, if the A 4.9 0.75% 15security is susceptible to redemption or if the rating BBB 4.9 1.76% 36should be amended. BB 4.9 2.01% 41 Moodys Corporate Bond Indexes Source: Bloomberg 10% 9% E.g., if the spread for AA corporate bonds should increase by 14 basis points (bps) over the course of 8% the next 12 months, the returns associated with 7% corporates will underperform comparable maturity Treasuries. This is calculated as the finance spread 6% in basis points divided by duration or 14 bps = (71 5% bps ÷ 4.9 years). 4% Corporate Spread B/E Analysis 3% (Basis Points) Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 250 Moodys Aaa Corp Moodys Aa Corp 200 Moodys A Corp Moodys Baa Corp 150By the conclusion of the 1st quarter 2013, Aaa andBaa corporate bond yields, as measured by the 100Moody’s Indexes, were at 3.90% and 4.83%,climbing from 3.67% and 4.63%, respectively, as of 50the conclusion of the 4th quarter 2012. Thesefigures might be compared to the yields of 1.850% 0and 3.103% associated with on-the-run (OTR) 10- AA A BBB BBand 30-year Treasuries. Dec-08 Dec-10 Mar-13 Source: BloombergFixed income portfolio managers must, of course, E.g., the breakeven spread advance for A-rateddecide whether to allocate assets to Treasury or corporates is 15 bps (=75 bps ÷ 4.9 years).corporate securities. One critical central questionbecomes – how many basis points must the spread E.g., the breakeven spread advance for BBBbetween corporates and Treasuries widen before corporates is 36 bps (=176 bps ÷ 4.9 years).corporates actually underperform Treasuries?7 | Interest Rate Market Monitor 1st Quarter 2013 | April 6, 2013 | © CME GROUP