Concerns over U.S. credit conditions, volatile stock prices and a weakening U.S. economy proved dominant for both U.S. interest rate direction and volatility in 2007.  Although U.S.  inflation drivers arguably became more numerous amid a weaker dollar and higher commodity prices over the final months of the year, the impact on interest rates proved relatively insignificant, at least so far.  

January 2, 2008:  Two and 3-year U.S. swap rates fell each month from July through December 2007, 6 straight months while 5-year swaps increased fractionally in December after falling for 5 straight months.  Fear and anxiety dominated the U.S. interest rate environment since the beginning of August as worsening financial conditions resulted in a weaker growth outlook, more accommodative monetary policy and a noticeable increase in market volatility.  Between September 18 and December 11, the FOMC cut its target fed funds rate by 100 bps to 4.25%.  In December, 2 and 5-year U.S. swap rates fell to the lowest levels seen since June 2005 amid a continued flight-to-quality into U.S. Treasuries.  Although additional rate declines were not priced into forward 3 to 5-year U.S. swap rates at the end of 2007, short-term U.S. Libor rates are expected to decline.  2007's yield declines left U.S. Treasuries with their best annual returns since 2002.

Rate changes for full year 2007 were as follows:

Market concerns:  U.S. interest rate volatility reached a 52 month high on December 20, 2007 after reaching a record low on May 15, 2007.  Last spring was indeed the calm before-the-storm. Heightened concerns over the earnings of financial firms and shifts in U.S. equity markets have impacted interest rate behavior more than other considerations in recent months.  Although there is still no overwhelming consensus that the U.S. economy is headed for recession in 2008, the expectation of slower economic growth - from continued weakness in the housing sector combined with anticipated slowing in business investment and personal consumption - is proving dominant.  The Dow Jones Industrial Average and the S&P 500 equity index increased a respective 6.4% and 3.5% in 2007.   Such gains, although being viewed by some as supported by the prospect of further Fed rate cuts, adds some level of doubt to the likelihood of a pending U.S. recession.  The most recent Bloomberg consensus forecast for U.S. GDP (comprised of 63 forecasts dated Dec 11), anticipates growth slowing to a 1.00% rate in Q4 2007 (from 4.9% in Q3 and 3.8% in Q2 '07) and then rising to 1.5% in Q1, 2.1% in Q2 and 2.5% in Q3 2008.

Inflation risks:  Although the market remains disproportionately concerned about the risks for weaker U.S. growth, several variables are likely to maintain inflation pressures.  We head into 2008 with the U.S. CPI up 4.3% (latest Nov yoy) compared to 2.5% at the end of 2006 while 2-year Treasury yields declined 176 bps and 5-year yields have dropped 125 bps in 2007.  Furthermore, the most recent PPI of 7.2% (Nov yoy), far exceeds the 1.1% end of '06 (yoy) level and import prices of 11.4% (Nov yoy) are well above the 2.5% (yoy) pace seen at the end of '06.  The trade weighted U.S. dollar declined 7% in 2007 and commodity prices surged.  Some 2007 highlights; the price of crude oil rose 57%, wholesale gasoline increased 55%, gold prices rose 31%, corn prices increased 17%, wheat prices increased 77%, cocoa prices rose 24% and cotton prices increased 21%.  According to the U.S. CPI data, dairy prices increased at a 15% 2007 rate through November (most recent).

Will the inflation focus - last seen dominant in May and June -  resurface as a consideration for higher interest rates?   Based on all the considerations that impacted U.S. interest rates in 2007 (discussed in detail below), it appears that a sustained period of orderly credit markets combined with evidence of housing market stability would likely be necessary to enable inflation concerns to drive U.S. yield movement for more than a day or two.  

All said, the risks for higher U.S. import, producer and consumer prices are not insignificant.  Furthermore, many of the price gains seen in 2007 - in a number of categories - may have become permanent.  Persistent global demand for numerous categories of commodities appears rather entrenched.  Crude oil prices reached a record $100.00 a barrel earlier today, more than $4 above where crude ended 2007.  China's currency rose to 7.2971 : $1 at the end of 2007, the highest since ending its fixed link to the $ in Jul '05 and is up ~ 11.7% since.  A stronger yuan raises the risk of higher US import prices.  Higher retail gasoline prices are again becoming a concern. Today, wholesale gasoline prices reached a record high $2.578 a gallon.

Fed expectations:  Futures anticipate the target fed funds rate declining roughly 100 bps from its current 4.25% by the end of 2008.  As recently as October 16, the target fed funds rate was not expected to end 2008 below its current 4.25%.

Yield curve is inverted:  Three-month U.S. Libor set at 4.70250% at the end of 2007, its lowest level since February 1, 2006.  At the end of 2007, the U.S. interest rate swap curve (out to 10-years) was inverted to short-term Libor with 3-year swap rates approximately 80 bps below 3-month Libor. Over the past 20 years, 3-year U.S. swap rates have averaged approximately 85 bps above 3-month Libor.  In this context, fixed swap rates remain historically low relative to Libor.  Most often (85% of the time), medium and long-term U.S. interest rates remain above short-term rates as compensation to investors for the greater price risk associated with longer term investments. 

Libor expectations:   According to today's futures market, 3-month U.S. Libor is expected to end 2008 at 3.25%, approximately 143 bps below today's setting of 4.68063%.  As recently as August 28, 2007, 3-month U.S. Libor was expected to end 2008 at 4.68%.

Volatility:  According to our count, out of 250 trading days in 2007,  98 of those days (39% of the time) witnessed 5-year Treasury yields move more than 5 bps (either higher or lower).  For all of last year (2006) per our count, 5-year Treasury yields moved more than 5 bps on a given trading day (higher or lower) 24% of the time.  During the last 6 months of 2007, 5-year Treasury yields moved more than 5 bps (higher or lower) on a given trading day 58% of the time compared to 25% during the second half of 2006.

Most volatile days (top 12) of 2007:  Using the 5-year U.S. Treasury yield as our measure, there were 34 separate trading days in 2007 that experienced 5-year Treasury yields moving at least 10 bps (higher or lower) - in 2006, there were just 6 days by comparison.

• The largest daily movement in 5-year U.S. Treasury yields in 2007 occurred December 11 when the yield fell 24.5 bps after the FOMC disappointed the market by cutting the fed funds and discount rates by 25 bps each.  Many market participants had anticipated a 50 bps drop in the discount rate and a more dovish FOMC statement.

• 2007's second largest daily movement in 5-year Treasuries occurred on November 21 when yields fell 20 bps after the S&P 500 stock index fell to the point where its gain for the year was wiped out.  As stocks declined that day, 10-year Treasury yields fell below 4.00% for the first time since 2005 on concerns that the impact of mortgage defaults would spread through the economy.  

• The third largest daily movement in 5-year Treasury yields in 2007, down 19.9 bps, occurred November 26 after Goldman Sachs said HSBC might incur an additional writedown of $12 bn due to bad credit exposures - yields fell on flight-to-quality Treasury buying.  

• The fourth largest daily movement in 5-year U.S. Treasuries occurred on July 26 when the yield fell 17.2 bps amid a 2.33% decline in the S&P 500 index.

• The fifth largest '07 daily movement in 5-year Treasuries occurred on November 27 after the president of the Philadelphia Fed, Charles Plosser, said the Oct 31 FOMC rate cut (of 25 bps) raised the risk for inflation and may need to be reversed if consumer prices climbed.  On that day, 5-year Treasury yields increased 17.1 bps.

• 2007's sixth largest daily movement in 5-year rates occurred September 7 when Treasury yields fell 16.8 bps following the first monthly job decline in 4 years (Aug nonfarm payrolls were originally reported down 4k on that day). 

• The seventh largest daily movement in 5-year Treasuries in '07, falling 15.8 bps, took place November 1 after Citigroup and Bank of America were downgraded by CIBC and Morgan Stanley.  That same day, Credit Suisse announced a $1.9 bn writedown.  The news shook financial stocks due to the uncertainty of future earnings.

• The eighth largest daily movement in 5-year Treasuries in '07, rising 15.6 bps, occurred September 20, just 2 days after the FOMC cut its target funds rate by 50 bps.  At that time, the market feared additional Fed rate cuts might lead to additional U.S. dollar weakness and higher inflation.  The heightened  inflation concerns did not persist for very long.

• The ninth largest '07 daily movement in 5-year Treasuries occurred August 9 when rates dropped 15.3 bps amid the S&P 500 declining 2.96% following news that funds at foreign banks were confronting liquidity problems. 

• The tenth largest daily movement in 5-year Treasury yields occurred November 15 when rates also dropped 15.3 bps after Barclays Bank wrote down $2.7 bn of bad credits related to subprime mortgages.  

• The eleventh largest daily movement in 5-year U.S. Treasuries took place on November 19 when rates fell 15.2 bps after Goldman Sachs said Citigroup may incur an additional writedown of $4 bn for a total of $15 bn on bad credits.  

• The twelfth largest '07 daily movement in 5-year Treasury yields occurred on February 27 amid a 3.47% decline in the S&P 500 equity index.  On that day, 5-year T yields fell 15.1 bps amid a significant reallocation into safe-haven Treasury assets.

2007 volatility, month by month:  According to our count, the 98 days experiencing 5-year Treasury yield movement of at least 5 bps (higher or lower) in 2007, occurred unevenly over the course of the year; 3 days in January, 4 in February, 3 in March, 4 in April, 2 in May, 9 in June, 10 in July, 14 in August, 10 in September, 9 in October, 14 in November and 16 in December.  

What moved interest rates in 2007?  According to our count, the most noticeable daily U.S. interest rate volatility resulted from 6 themes, a) Capital reallocation within the financial markets from one asset class to another (on 24 days), b) U.S. employment related data (11 days), c) Communications from the Federal Reserve (11 days), d) Inflation considerations (11 days), e) News of liquidity problems at financial institutions (10 days) and f) U.S. housing sector concerns (9 days).  

Robert Podorefsky, Interest Rate Strategist (617) 973 - 4091