Trading in US interest rate markets during 2007 was, to draw upon a sporting analogy, a game of two halves.

“By May there was not one investment bank economist calling for a rate cut at the end of the year,” says Tom di Galoma, head of Treasury trading at Jefferies & Co. “The market was scared that the Fed would raise rates, but that was pretty much the peak in rates.”

Between early May and June, Treasury yields surged higher and interest rate futures had erased all prospect of a rate cut in 2007. The move was compounded by mortgage investors selling Treasuries and swaps in order to maintain balanced portfolios. Meanwhile, there was fear that foreign holders of Treasuries would diversify their holdings as the dollar weakened.

By the time the sell-off had abated, the yield on the two-year note was about 5.10 per cent, while the 10-year was yielding 5.25 per cent, in line with the then Fed funds rate.

Fast forward to December and the credit and mortgage storm ensnaring financial institutions has sparked three rate cuts from the Federal Reserve that leaves the funds rate at 4.25 per cent.

Earlier this month the yield on the policy sensitive two-year note was below 3 per cent. The yield on the 10-year note traded under 4 per cent, but is now at about the current funds rate.

The dramatic turnround in yields since summer means Treasury bond returns will stage their best total return in five years.

The Lehman Brothers Treasury index has generated a total return of 8.1 per cent, its best run since a rise of 11.79 per cent in 2002. From 2003 to 2006, returns on Treasuries have been between 2.24 and 3.5 per cent.

Treasury inflation protected securities have also done well, with the Lehman TIPS index up 10.1 per cent in 2007, its best run since a rise of 16.56 per cent in 2002.

Worries over inflation have been stoked by rate cuts in the face of the credit squeeze. Recent inflation reports revealed higher than expected price pressures in November and that has pushed bond yields higher.

The cut in the Fed funds rate is just part of the story behind the sharp gains in Treasuries this year. In spite of concern over inflation, the current level of Treasury yields implies further pain for the economy and possibly a recession.

“Consensus is moving from whether or not there will be a recession, to how severe of a recession it will be,” says Jack Ablin, chief investment officer at Harris Private Bank.

With housing prices forecast to fall further in 2008, energy prices near record levels and consumers facing higher interest rates thanks to the credit squeeze, many economists still expect more rate cuts. Interest rate futures suggest the funds rate will trough at about 3.5 per cent late next year.

“There are a lot of headwinds for central banks and the effectiveness of monetary policy,” says Nicolas Beckmann, head of rates trading at BNP Paribas.

Economists at Morgan Stanley say a mild US recession is now likely, with no growth for the year ahead and they expect the funds rate will fall to 3.50 per cent by the end of March in 2008.

Such an outlook suggests further gains for Treasuries, led by the policy sensitive two-year note. It also suggests a much steeper yield curve, a trend that would gather speed should inflation remain a worry as longer-dated bonds are primarily influenced by expectations of future prices.

The current difference in yields between the two- and 10-year notes is about one percentage point. In April, both yields were about 4.60 per cent, creating a flat yield curve. Earlier in the year, the relationship between two- and 10-year note yields was negative, indicating that bond investors expected the economy was heading for a recession.

Further rate cuts are likely to steepen the yield curve to between 1.50 and 2 percentage points, traders say. This will help banks, which borrow money for short periods and invest the proceeds in longer-dated securities.

As the year-end approaches, stresses remain high in the money markets. Interest rate swaps, which measure the difference between Treasury and money market rates, have blown out to their widest levels since 2000. The two-year swap spread closed at a record level of 107 basis points above the two-year Treasury note yield this month.

It is by no means clear that recent injections of liquidity by central banks will resolve the situation. There is also a strong sense that once banks negotiate the end of the calendar year, conditions in the money market will remain constrained, supporting short-dated Treasury securities.

“This is not a year-end phenomenon, it will continue next year according to forward measures of Libor,” says Dominic Konstam, head of interest rate strategy at Credit Suisse.

This sense of uncertainty about what the credit squeeze entails for the broad economy is illustrated by the continued rise in Treasury volatility.

The Merrill Lynch Option Volatility Estimate, known as Move, tallies 30-day Treasury option volatility. Move set a record low of 51.20 on May 15, only to start surging in August. After the Fed meeting in December, Move set a high of 142.80, up nearly 180 per cent from its low in May. By comparison, Move spent 2006 in a range of 55 and 75.65.

“We are heading into 2008 with a deteriorating credit story and a dislocated money curve,” says Mr Beckmann.

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