Since we published the February issue of What Counts, the spread between one- and ten-year advance yields increased, from 15 basis points to 19 basis points. The yield spread between three-month and two-year advance rate narrowed to 24 basis points, from 34 basis points. The two-year sector has been strongly bid due, in part, to speculation of a postponement of the March 29 Treasury auction. 

The relative “roll-down” benefit in the two-year sector increased to 3 basis points, from one basis point.  From a historical perspective, virtually all points on the yield curve continue to provide equal, albeit insignificant, amounts of incremental insurance against the potential of rising rates.

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

• Purchase a one-year, fixed-ncome security (assumed to be pegged to the Seattle Bank yield curve), in this example, 5.18%
• Purchase a two-year, fixed-income security and sell after one year, in this example, 5.19%

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 is now 3 basis point of protection (versus one basis point 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. At current levels, an investor would be relatively indifferent to either option. 

The attached chart of current-versus-future implied swap yield curves suggests that longer-term rates are expected to show little change from current levels. Conversely, the market appears to be discounting short-term rate increases on the order of 50 basis points over the next six months. Thereafter, the market appears to be discounting stable-to-slightly-declining short-term rates.

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