Interest Rates, U.S.

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

Fed policy – US interest rates during 2003 trended lower early in the year due to weak economic growth tied to the impending Iraq war. Interest rates then moved higher over the summer after the economy started to recover. The Federal Open Market Committee (FOMC) came into 2003 with its overnight federal funds rate at 1.25% but the FOMC then cut its funds rate target by another 0.25% to a 45-year low of 1.00% on June 25 to ensure an economic recovery. As 2003 ended, the market was expecting the Fed to raise its funds rate target by 25 bp by summer 2004 and by another 25 bp by autumn 2004.

The Fed’s extraordinarily accommodative monetary policy during 2003 was designed to ensure that the US economy would get back on its feet. The US economy had taken some major hits in the previous two years, with the stock market bubble bursting in 2000, the 9/11 terrorist attack in September 2001, and the corporate scandals seen through 2002 and 2003. Those external shocks, combined with the impending war with Iraq in early 2003, caused concern that the US might slip into another recession and that deflation could become a serious problem. But by late 2003, the Fed’s extremely stimulative monetary policy, combined with the expansive fiscal policy, helped create an economic boom and US GDP soared to +8.2% by Q3.

Treasury supply – The Treasury in 2003 made some substantial changes to its debt auction schedule due to the US budget deficit, which soared to $401 billion in fiscal 2003 and is expected to be near $480 billion in fiscal 2004. The higher budget deficit is due to three main factors: (1) lower revenues with the weak economy, (2) high expenses from the war on terror and the wars in Afghanistan and Iraq, and (3) the Bush tax cuts. The Treasury in 2003 revised its auction mix by (1) selling 5-year T-notes monthly versus its previous pattern of eight sales per year, (2) reinstating a quarterly sale of 3-year T-notes (after a 5-year hiatus), (3) increasing the frequency of 10-year T-note sales to eight per year from four per year, and (4) increasing the frequency of inflation-indexed 10-year T-notes to four per year.

Treasury yield curve – The Treasury yield curve was extremely steep during 2003. The Fed’s extraordinarily easy monetary policy and the funds rate target of 1.00% kept short-term interest rates locked down to extremely low levels. Longer-term rates, however, were higher as the market discounted a return to a more normal inflation and interest rate situation in coming years. The spread between the 10-year T-note and the 2-year T-note, a widely-watched indicator of yield curve steepness, rose to 2.73 percentage points in July 2003, which was a record high going back to the beginning of the data series in 1977.