Seattle Bank Yield Curve Optimal Points Analysis

Since July, the spread between one- and 10-year advance yields has decreased from 297 basis points to 273 basis points, with a continued flattening of the yield curve in recent weeks. The spread between three-month and two-year advance rates increased slightly from 39 basis points to 43 basis points, notwithstanding the dramatic flattening that took place during July.

The relative “roll-down” benefit in the two-year sector increased from 51 basis points to 69 basis points, implying that there remains an increasing degree of benefit to investing in a two-year, versus a one-year, security. It also means that there is a decreasing amount of 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 the Seattle Bank Yield Curve), in this example, 0.68%.
  • Purchase a two-year, fixed-income security and sell after one year, in this example, 0.95%.

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 declining 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 only slightly better off by investing in a two-year security. Conversely, a borrower would be only slightly 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 chart of current-versus-future implied swap yield curves provided below suggests that rates are expected to slightly increase in the very short end of the yield curve over the next 12 months, by 10 to 25 basis points. Longer-term rates are expected to increase by 25 basis points, contrasting somewhat with the median view of most economists, who believe that longer-term rates will increase by on the order of 75 basis points from current levels. Short-term forward rates correlate with the views of most economists.