A.M. Best Special Report: 2nd-Quarter Interest Review -- Inflation Concerns Push Yield Curve toward Normal Slope.

OLDWICK, N.J. -- After a year under water, the U.S. Treasury yield curve has resumed a normal, positive slope, with long-term yields higher than short-term yields. As viewed using six-month and 10-year Treasury securities, the yield curve turned negative June 2, 2006, nearly four weeks in advance of the Federal Reserve's June 29 final tightening action of the last interest-rate cycle, this according to a special report by the A.M. Best Co.

In the year that has followed, credit market sentiment has gyrated around when the Fed might begin to ease in order to stimulate a flagging economy. Following the sequence of numbered curves provides a sense of how variable expectations have been. As suggested in the 2007 Special Report--U.S. Banking: 1st-Quarter Interest Review, "... consensus forecasts of a looming Fed easing remain at risk of being frustrated." Those expectations now have been frustrated, at least temporarily, as credit market sentiment in the past month has shifted focus to inflation concerns and toward accelerating instead of slowing economic activity.

Despite the market's mood swings, the underlying fundamentals have changed little in the past quarter, and new expectations of a looming Fed tightening also may be frustrated in the months ahead, unless circumstances beyond its control force the U.S. central bank to act.

Economic growth slowed to a near halt in the first quarter of 2007, based on current reporting of the gross domestic product. Although some in the markets anticipate an economic rebound, the U.S. economy rarely changes direction quickly, and such shifts normally are foreshadowed by parallel movement in leading indicators. Since the more reliable indicators have not turned to the upside, risk is high that recent strength seen in some May data may be just fleeting aberrations of unusual weather or seasonal factors. Renewed reporting of a downturn in business activity could quickly fuel renewed speculation of Fed easing.

Inflation, however, remains strong and appears likely to persist for the near term. Unfortunately from the Fed's standpoint, current inflation is driven largely by distortions in commodity prices (i.e., cartel-influenced oil and drought-impacted food). That means current inflation would not respond easily or quickly to higher interest rates, while at the same time higher rates would tend to soften economic activity further. Raising interest rates is more effective in combating higher prices when strong economic demand drives the price increases.

An ongoing conflict between a soft economy and rising inflation remains a good bet to hold Fed policy in check for a while. Beyond economic activity and inflation, the Fed's concerns center on maintaining orderly and liquid financial markets. Accordingly, the upside risk to Fed interest rate policy remains the U.S. dollar. With the U.S. markets so heavily dependent on foreign capital for liquidity, heavy selling pressure against the greenback could trigger a defensive rate hike by the Fed. The downside risk to Fed interest rate targets remains any systemic liquidity crisis that might evolve from any number of factors. These include market distortions created by problems from nontraditional loan underwriting, as already has started to surface in the subprime, adjustable-rate lending market.

In any event, the positively sloped yield curve likely will hold for the near future. While it is not clear what portion of the banking industry was positioned to take advantage of the recent relative gain in longer-term versus shorter-term interest rates, the positively sloped yield curve offers banks a more comfortable and standard pricing environment for the future. As discussed in the 2007 Special Report--U.S. Banking Issues: Loan Margin Pressures Collide with Rising Credit Costs, the recent negatively sloped yield curve was a factor in compressing net interest margins industry wide.

This special report is available electronically from the A.M. Best Company Web site at www.ambest.com/banks.

Call customer service for more information [phone], ext. 5742.

Founded in 1899, A.M. Best Company is a full-service credit rating organization dedicated to serving the financial services industries, including the banking and insurance sectors. For more information, visit www.ambest.com.