Since we published the November issue of What Counts, the spread between one-year and 10-year advance yields decreased, from 41 basis points to 31 basis points. The yield spread between three-month and two-year advance rate narrowed to 43 basis points, from 59 basis points.

The relative “roll-down” benefit in the two-year sector decreased to 13 basis points, from 23 basis points. Virtually all points on the yield curve continue to 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:

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 13 basis points of protection (versus 23 basis points 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. The investor would have made the right decision, unless rates were to increase by more than 13 basis points during the one-year period.

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 25 basis points over the next three months, along with another 25 basis points by the end of the sixth month. Thereafter, the market appears to be discounting stable short-term rates.

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