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- CRB Fundamentals - 2008 Commodity Articles

Interest Rates, U.S.

US interest rates can be characterized in two main ways, by credit quality and maturity. Credit quality refers to the level of risk associated with a particular borrower. U.S. Treasury securities, for example, carry the lowest risk. Maturity refers to the time at which the security matures and must be repaid. Treasury securities carry the full spectrum of maturities, from short-term cash management bills, to T-bills (4-weeks, 3-months, and 6-months), T-notes (2-year, 3-year, 5-year and 10-year), and 30-year T-bonds. The most active futures markets are the Treasury note and bond futures traded at the Chicago Board of Trade (CBOT) and the Eurodollar futures traded at the Chicago Mercantile Exchange (CME).

Prices - 10-year T-note futures prices in the first several months of 2007 traded basically sideways in a narrow range, after rebounding upward in late 2006 when the Fed ended its 2-year tightening regime. The Fed from mid-2004 through mid-2006 raised its federal funds rate target by a total of 425 basis points from the 1.00% level that prevailed from mid-2003 to mid-2004 to 5.25% by June 2006.

After the quiet trading in early 2007, 10-year T-note futures prices then sold off sharply by 5 points in May and June 2007 and the 10-year yield rose sharply by about 75 bp from 4.50% to a peak of 5.34%. The sell-off in T-note prices was due to strong GDP growth in the U.S. and overseas, rising inflation, and the 25 basis point rate hike by the European Central Bank in June 2007.

The rise in T-note yields above 5.00% in May and June turned out to be the straw that broke the camel's back. Mortgage-backed securities had already been selling off sharply due to increasing mortgage defaults and the rise in yields above 5.00% simply accelerated the process. In August, the sub-prime mortgage problem blew wide open and a systemic threat to the banking system quickly ensued.

T-note prices rallied sharply starting in August when the banking system crisis started as the U.S. Federal Reserve and the European Central Bank started to inject a huge amount of reserves into the banking system. Treasury securities also rallied on flight-to-quality as investors dumped higher risk securities and fled to the safety of direct debt obligations of the U.S. federal government. The Fed initially tried to address the crisis with just reserve injections, but was eventually forced to cut its federal funds rate sharply by 100 basis points to 4.25% by the end of 2007 and further to 3.00% by February 2008. T-note prices from mid-2007 through early 2008 rallied very sharply by 15 full points, and the 10-year T-note yield fell from the high of 5.34% in June 2007 to the 3.50% area by early 2008.

Aside from the trouble in the banking system, the U.S. real economy also hit the skids by late 2007 as U.S. consumers were blindsided with falling home prices and much tighter restraints on the availability of mortgage and other credit. U.S. consumers were also hit with a rise in oil prices above $100 per barrel and gasoline prices above $3.00 per gallon, an event that by itself in previous decades would have caused a U.S. recession. U.S. GDP was strong during mid 2007, but then fell to +0.6% by Q4-2007. As of early 2008, the market was discounting a better than 50-50 chance of a U.S. recession in 2008.




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