Seattle Bank Yield Curve Optimal Points Analysis

Since we published the August issue of What Counts, the spread between one-year and 10-year advance yields remained unchanged at 64 basis points. The yield spread between three-month and two-year advance rates narrowed significantly to 38 basis points, from 71 basis points.

The relative “roll-down” benefit in the two-year sector decreased, from 37 to 19 basis points. Virtually all points on the yield curve provide equal, albeit limited, amounts of incremental insurance against the potential of rising rates.

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

1.
 Purchase a one-year, fixed-income security (assumed to be pegged to the Seattle Bank Yield Curve), in this example at 4.22%.
2.
 Purchase a two-year, fixed-income security , in this example at 4.31%, and sell after one year.

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 would like to 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 19 basis points of protection (versus 37 basis points one month ago) from rising rates over a one-year period for an investor that opts to purchase a two-year security and sell it at the end of the first year. An investor would have made the right decision, unless rates were to increase by more than 19 basis points during the one-year period.

The following chart of current-versus-future implied swap yield curves suggests several changes in market perception compared with a month ago. First, spreads at the short-end between the current yield curve and implied forward yield curves have contracted. Second, certain points on the projected one-year curve are now less than those on the projected six-month curve. These observations are generally associated with the perception of the Federal Reserve possibly nearing the end of its tightening cycle.