Seattle Bank Yield Curve Optimal Points Analysis

Since October, the spread between one- and 10-year advance yields has expanded, from 55 basis points to 79 basis points. The inverted spread between three-month and two-year advance rates has modestly expanded, from negative 23 basis points to negative 24 basis points.

The relative “roll-down” benefit in the two-year sector narrowed, from positive three basis points to negative 19 basis points. This implies that there is still no relative benefit of investing in a two-year, versus a one-year security.

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 Yield Curve), in this example, 4.50%.
  • Purchase a two-year, fixed-income security and sell after one year, in this example, 4.40%.

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, by historical standards, minimal protection from rising rates over a one-year period for an investor opting to purchase a two-year security and sell it at the end of the first year. At current levels, the current implied forward yield curve indicates that an investor would be not be better off by investing in a two-year security. Conversely, a borrower would be relatively better off by borrowing in the two-year sector.

The attached chart of current-versus-future implied swap yield curves suggests that short-term rates are expected to decline on the order of 45 to 65 basis points over the next 12 months. Longer-term rates are expected to increase on the order of 10 basis points one year from now. These variables would suggest future steepening of the yield curve.