Quarterly Interest Rate Review

INTEREST RATES Second Quarter 2015 Quarterly Interest Rate Review A Global Trading Summary of Interest Rate Futures, Options and OTC Products»» Highlights»» Quarterly Outlook»» Product Overview How the world advances

QUARTERLY OUTLOOK Market Insights with CME Group Chief Economist Bluford Putnam There are many signs suggesting that the US Federal Reserve s FOMC (Federal Open Market Committee) is very close to reaching a compromise among its members so that a decision to abandon zero-rates might be made at the 15-16 September meeting. While the timing of the rate-hike decision remains ambiguous, here is a review of the data revealing why a decision could come sooner rather than later. Monthly job growth and the unemployment rate are both providing exceptionally healthy readings. With some typical volatility, the economy is adding 225,000 or so net new jobs every month. The unemployment rate is comfortably under 5.5%. Over the last 40 years, the unemployment rate has averaged 6.2%, and has only been below 5.5% about 40% of the that time. There are members of the FOMC, including Fed Chairwoman Janet Yellen, that take a more holistic view of the labor markets, and they still have concerns related to the decline in the labor participation rate and the slow growth in the hourly wage rate. These are not new challenges for the economy and they are almost certainly of a structural nature that is not amenable to inflence by the Federal Reserve s QE or interest rate policies. The labor participation rate has been declning since 2000, well before the Great Recession of 2008-2009. Analysts cite many reasons, yet not all of the decline can easily be explained. We know the labor force is aging and this has increased the drop-out rate. Disability insurance has also become a slightly more attractive alternative for some (eligible) former workers. Millinials appear to be more entrepreneurial and may not be counted in the same frequency as in the past. What we do know is that the labor participation rate is not particularly influenced by the level of interest rates. The Fed can worry about a declining labor participation rate, but it cannot do anything about it, and afterall, the economy is creating new jobs at a very robust pace. Hourly wages are growing only slowly, although they are rising incrementally faster than the core inflation rate, meaning that real, or inflation-adjusted, hourly wages are just barely staying ahead of the game. The challenge here appears to relate the changing structural nature of employment related to problem-solving jobs which are in tighter supply and more repetitive, retail, or factory jobs which face steep competition from a dynamic and highly competitive world market. There are two points to consider. First, like the labor participation rate, hourly wage growth is unlikely to be influenced by the level of interest rates. Second, hourly wage growth vastly underestimates the overall growth in labor income in the US over the last five years. Total labor income growth results from the pace of net new job creation, as well as wage growth, and the former has been quite healthy even if the latter has been quite modest. Finally, we note that the core inflation rate remain just under the Fed s long-term 2% target. What is not often appreciated, though, is that the core inflation rate has bounced in a very narrow range, from 0.90% to 2.45% over the last two decades, and the movement within that range has been nothing but noise. Core inflation has been so stable since 1994, that it was hardly moved by the stock market tech rally, the tech wreck, the housing boom, the spectacular bust, or five-plus years of QE and zero rates The key for the Fed is that there are no signs of deflationary pressure and inflation is not far away from the 2% target. The base case scenario is that five-plus years of modest real GDP growth and solid jobs growth argue that the Fed no longer needs to retain the emergenncy measures of the Bernanke-Fed, including zero short-term rates. Within the FOMC, among the hawks and doves, the likely compromise is to make the first rate hike in September (or very soon after), make future moves in small steps (0.25%), skip a few meetings in between, and finally, stop the rate rises around 1.5% or 2% -- when the federal funds rate is more or less equal to the core inflation rate. For more of Blu s views and commentary, visit cmegroup.com/putnam All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. 7This report and the information herein should not be considered investment advice or the results of actual market experience. 1

PRODUCT OVERVIEW EURODOLLAR FUTURES AND OPTIONS Increase in Options Traded Electronically Eurodollar Options ADV and % Electronic Eurodollar Futures average $2.5 Trillion notional per day in volume, with activity in the front 8 up 12% over Q2-2014. Eurodollar Options ADV reached 827,427 contracts in Q2 2015, and open interest peaked at over 31.4 million contracts prior to June expiration Eurodollar Options globex volume averaged over 176,000 contracts per day in June, and Q2-2015 electronic percentage was a record 19%. 160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 0 Globex ADV % Electronic Q1-2014 Q2-2014 Q3-2014 Q4-2014 Q1-2015 Q2-2015 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Eurodollar Options move to Quarterlies and Serials As Eurodollar Option volumes build, we see particularly large growth from the quarterly options (grey bars on right graph). This is an indication of increasing client interest in trading the front of the curve, as this is the busiest the product has been since 2011. Participation in mid-curve options remains robust, as they continue to average over 500,000 contracts per day vs. just 366,000 in 2011. FED FUNDS Fed Funds Large Open Interest Holders (LOIH) on the Rise Fed Fund futures have seen a huge resurgence over the last 12 months The Large Open Interest Holder s report indicates that participation is growing with firms getting involved for the first time. Options averaging over 1,400 contracts per day in 2015. 2

TREASURY FUTURES AND OPTIONS Futures ADV Jumps Relative to Cash Chart depicts notional volume in Treasury Futures versus notional volume of Cash Treasury Securities, over the last decade. Continued increase in futures as a percentage of cash, reaching 78% so far this year. Growing participation in Ultra Bond Futures Ultra T-Bond Futures (launched 2010) continue to develop interest from clients seeking exposure to long duration interest rates. ADV increased to 115,000 contracts in Q2-2015, up 21% from the previous year. Open interest reached 587,000 contracts at the end of the quarter, up 22% from the same point last year Weekly Treasury Options (WTOs) ADV reaches a new high Treasury Options averaging 636,000 contracts per day in Q2 Interest in weekly options continues to soar, with customers looking to pinpoint their trading around specific economic events. Volumes averaging 107,000 contracts per day, up 86% from last year. For example, on Wednesday July 1 we saw 348,899 WTO s trade, a single day record and 45% of all Treasury Option volume on that day. We also saw an O.I. record (597,000 contracts) on the same day. Use CME Group tools to learn more about which weeklies are most active. 3

IR TRENDS & EVENTS Eurodollar Bundle Futures and Options Now offering 100% Margin Offsets with existing CME Eurodollar Futures CME Eurodollar Bundle futures and options provide an operational and capital efficient means for trading long-dated Eurodollar exposure, linked to the world s deepest futures liquidity pool. Bundle Futures are available in 2-Year, 3-Year, and 5-year trading increments, with simultaneously listed options, offering: Operational simplicity: Single line item, 1 million in notional value, easy execution Capital efficiency: 100% margin offsets with Eurodollar futures and efficient margin treatment due to single-line-item nature Simple, transparent average pricing: Allows ability to associate with yield levels Options: Creates an efficient alternative to OTC bilateral products Download the Eurodollar Bundle Toolkit Additional Resources Product Overview Presentation Futures Reference Guide Options Reference Guide Historical Pricing Data Notional Value Paper Delivery Process Paper Hedging IRS Paper 4

IR TRENDS & EVENTS CBOT Deliverable Swap Futures: A Capital Efficient Addition to Your Cleared Swap Portfolio The Internal Revenue Service published a new rule for Swaps with Nonperiodic Payments, eliminating the tax concern for trading Deliverable Swap Futures (DSFs). With an average of $647 million in notional traded per day and open interest over $9 billion in notional, DSFs are one of the most liquid CLOBs for trading interest rate exposure. Portfolio Margining of DSFs with OTC IRS Offers Savings Between 79%-85% USD DSF Strategy* Margin if Cleared Separately CME Portfolio Margin Margin Savings Savings Percentage 5YR DSF vs 5YR IRS 49,138,068 9,918,624 39,219,444 80% 10YR DSF vs 10YR IRS 48,028,638 7,070,027 40,958,611 85% 30YR DSF vs 30YR IRS 52,165,783 10,893,739 41,272,044 79% *Examples of USD DSF across tenors (5, 10, 30 years) with $1 million DV01 in each strategy. Benefits of Deliverable Swap Futures: Futures margin efficiency afforded to standardized products, with delivery certainty into a MAC swap Automatic margin offsets are available against Eurodollar and Treasury futures enabling capital savings and relative value strategies Low block thresholds, including calendar rolls For more information, visit cmegroup.com/dsf 5

IR TRENDS & EVENTS Record Month for Compression via Coupon Blending $1.8 trillion of notional outstanding was eliminated in June Capital pressures have driven more clients to leverage the benefits of CME Group's Compression via Coupon Blending solution - reducing both the number of outstanding trades and the amount of gross notional in their portfolios. 181,000 trades blended since launching this solution, with 86% of those eliminated Nearly $10 trillion reduction in gross notional outstanding -- with a record $1.8 trillion eliminated in June 2015 alone Less pressure on you. More capital and operational efficiencies for your portfolios. To start using compression via Coupon Blending, click here. 6

IR Resources CME Direct: Bringing you all the features of EOS Trader, plus new block trade functionality Interest Rate futures, options and blocks all on one screen Delivered securely across the Internet, CME Direct is a highly-configurable trading front end for CME Group markets that offers a complete suite of solutions across the trading lifecycle. Real-time streaming quotes, including market depth Rapid order entry and trading across multiple accounts Supports all Globex order types, order duration and order protection functions Straight-through processing (STP) to your risk system for both listed and block trades Hyper-fast options functionality that allows traders to send RFQs and execute covered and multi-leg strategies on CME Globex Access to all Globex futures and options markets, including Eurodollars, Treasuries, Fed Funds, and Deliverable Swap Futures Now Available: Futures and Options Block Reference Guides Block trades are privately negotiated futures trades between two eligible counterparties which are subsequently submitted to the CME Clearing House for bookkeeping purposes. Block trades offer institutional traders the convenience of privately negotiating a futures transaction with a select eligible counterparty. In particular, institutions often seek to execute large transactions at a singular price while enjoying the benefits imparted by the financial sureties associated with the CME centralized counterparty (CCP) clearing system. View the Futures Reference Guide View the Options Reference Guide Learn more: Interest Rate blocks at cmegroup.com/interestrateblocks CME Direct at cmegroup.com/direct For product questions or to schedule a demo of CME Direct, contact cmedirectsales@cmegroup.com 7

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