U.S. interest rates can be characterized in two main ways, by credit quality and by 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, 6-months), T-notes (2-year, 3-year, 5-year, 7-year, and 10-year), and 30-year T-bonds. The most active futures markets are the 10-year T-note futures, 30-year T-bond futures, and Eurodollar futures, all of which are traded at the CME Group.
Prices - CME 10-year T-note futures prices posted a 3-1/2 year low in December 2013, but then rallied moderately during 2014 to post a new 1-1/2 year high. T-note prices traded sideways in the first half of 2014 as Fed policy remained steady and the U.S. economy picked up some steam. However, T-note prices then rallied and broke out to a new 1-1/2 year high in the latter part of the year due to the plunge in inflation expectations caused by the free-fall in crude oil prices.
T-note prices during 2014 were supported by the Fed's continued extraordinarily easy monetary policy as the Fed kept its federal funds rate target near zero all year. The Fed during 2014 progressively cut the size of its third quantitative easing program (QE3) by $10 billion per month at each FOMC meeting, finally making the final $15 billion cut at its October 2014 meeting. The end of QE3 did not have much impact on the T-note market since the Fed had been progressively cutting QE3 for over a year and had clearly telegraphed its intention to end QE3 in October 2014. The Fed is now keeping its balance sheet asset level unchanged near $4.5 trillion by rolling-over maturing securities.
Meanwhile, the plunge in crude oil prices in the latter part of 2014 had a bullish impact on the T-note market since inflation expectations fell sharply. The 10-year breakeven inflation expectations rate, which measures the difference between nominal and inflation-adjusted TIPS T-notes, posted a 7-year high of 3.00% at the beginning of 2014 but then fell as low as 1.60% in January 2015 after crude oil prices plunged. The plunge in crude oil prices pushed the headline U.S. inflation indexes lower and also put downward pressure on the core inflation indexes because fuel prices are such a key cost for a wide variety of products and services. The disinflation pressures caused by the plunge in crude oil prices also gave the Fed more flexibility to extend its extraordinarily easy monetary policy, which was a further supportive factor for T-note prices.
U.S. interest rates continue to trade at extraordinarily low levels due to the Fed's zero interest rate policy, low inflation, and weak global economic growth. However, the question is whether long-term interest rates will see significant upward pressure over the next few years as the global economy gains traction and as the Fed starts to drain excess reserves and raise interest rates. The federal funds market is currently expecting the Fed's first 25 basis point (bp) rate hike to 0.50% by November 2015. The market is then expecting three 25 bp rate hikes in 2016 and three more 25 bp rate hikes in 2017, thus bringing the federal funds rate up to 2.00% by the end of 2017. Those rate hikes would put significant downward pressure on T-note prices.
Articles from the Commodity Research Bureau (CRB) Commodity Yearbook. The single most comprehensive source of commodity and futures market information available, the Yearbook is the book of record of the Commodity Research Bureau, which is, in turn, the organization of record for the commodity industry itself. Its sources - reports from governments, private industries, and trade and industrial associations - are authoritative, and its historical scope is second to none. Additional information can be found at www.crbyearbook.com.