Since the May issue of What Counts, the one- to 10-year advance yield curve narrowed to 76 basis points, from 101 basis points. The yield spread between three-month and two-year treasuries also narrowed to 54 basis points, from 81 basis points.

The relative “roll-down” benefit in the two-year sector continued to flatten, from 57 to 35 basis points. The two-year sector now provides a negligible amount of incremental insurance against the potential of rising rates compared with longer points on the yield curve.

Consider the following investment alternatives covering a one-year time horizon:

	Purchase a one-year, fixed-income security (assumed to be pegged to Seattle Bank advance curve), in this example, 3.74%.
	Purchase a two-year, fixed-income security and sell after one year, in this example, 3.91%.

In deciding whether to purchase the one-year security, as opposed to purchasing the two-year security and selling it at the end of one year, an investor should know the answer to a key question: in the event of rising interest rates, even though a modest principal loss would be sustained, would the extra yield earned, relative to one-year portions of the yield curve, more than offset the loss?

Under current market conditions, there are now only 35 basis points of protection (versus 57 basis points one month ago) from rising rates over a one-year period for an investor who opts to purchase a two-year security and sell it at the end of the first year. The investor would have made the right decision, unless rates were to increase by more than 35 basis points during the one-year period.

As a new monthly feature of What Counts, the "Current vs. Implied Forward Rate Curve" suggests that markets are expecting little change in the shape of the yield curve beyond the three-year sector. Nevertheless, additional flattening is expected to take place in the short end of the yield curve.

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