Seattle Bank Yield Curve Optimal Points Analysis

Since June, the spread between one- and 10-year advance yields has widened from 381 basis points to 383 basis points. The spread between three-month and two-year advance rates decreased, from 121 basis points to 98 basis points.

The relative “roll-down” benefit in the two-year sector decreased from 175 basis points, to 141 basis points. This implies that there is benefit (albeit diminishing) to investing in a two-year, versus a one-year security. It also means that there is slightly less risk in obtaining funds in the two year maturity area, as opposed to either the short-end of the curve, or the intermediate (e.g. five-year) sector.

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, 0.96%.
  • Purchase a two-year, fixed-income security and sell after one year, in this example, 1.66%.

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, a moderate degree of protection 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. At current levels, the current implied forward yield curve indicates that an investor would be better off by investing in a two-year security. Conversely, a borrower would be relatively worse off by borrowing in the two-year sector and better off borrowing in the one-year sector (notwithstanding a borrower’s unique balance sheet, liquidity and other related considerations.)

The attached chart of current versus future implied swap yield curves suggests that rates are expected to increase in the very short-end of the yield curve over the next 12 months by on the order of 50-125 basis points. Longer-term rates are expected to increase by on the order of 25-50 basis points. This is roughly on par with the median view of most economists who believe that longer-term rates will increase on the order of 50 basis points from current levels.